wtp- 65 public disclosure authorized...the management contract offers a vehicle by which an...
TRANSCRIPT
WTP- 65
WBG
Management Contracts C
Main Features and Design Issues
Sven Olaf Hegstad and Ian Newport
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Management ContractsMain Features and Design Issues
Industry and Finance Series
Volume 22
This series is produced by the Industry Department of the WorldBank to disseminate ongoing work and stimulate further discussion. Theseries will include studies of individual sectors in industry, aspects ofworld industry, industrial strategy and policy, and industrial finance andfinancial development. Already published are the following:
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WORLD BANK TECHNICAL PAPER NUMBER 65
INDUSTRY AND FINANCE SERIES
Management ContractsMain Features and Design Issues
Sven Olaf Hegstad and Ian Newport
The World BankWashington, D.C.
The International Bank for Reconstructionand Development/THE WORLD BANK
1818 H Street, N.W.Washington, D.C. 20433, U.S.A.
All rights reservedManufactured in the United States of AmericaFirst printing July 1987
Technical Papers are not formal publications of the World Bank, and are circulatedto encourage discussion and comment and to communicate the results of the Bank'swork quickly to the development community; citation and the use of these papersshould take account of their provisional character. The findings, interpretations, andconclusions expressed in this paper are entirely those of the author(s) and should notbe attributed in any manner to the World Bank, to its affiliated organizations, or tomembers of its Board of Executive Directors or the countries they represent. Any mapsthat accompany the text have been prepared solely for the convenience of readers; thedesignations and presentation of material in them do not imply the expression of anyopinion whatsoever on the part of the World Bank, its affiliates, or its Board or membercountries concerning the legal status of any country, territory, city, or area or of theauthorities thereof or concerning the delimitation of its boundaries or its nationalaffiliation.
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The most recent World Bank publications are described in the catalog NewPublications, a new edition of which is issued in the spring and fall of each year. Thecomplete backlist of publications is shown in the annual Index of Publications, whichcontains an alphabetical title list and indexes of subjects, authors, and countries andregions; it is of value principally to libraries and institutional purchasers. The latestedition of each of these is available free of charge from the Publications Sales Unit,Department F, The World Bank, 1818 H Street, N.W, Washington, D.C. 20433, U.S.A.,or from Publications, The World Bank, 66, avenue d'1ena, 75116 Paris, France.
Sven Olaf Hegstad is senior industrial specialist in the Industry Department, and IanNewport is senior counsel, industry and mining, in the Legal Department, both at theWorld Bank.
Library of Congress Cataloging-in-Publication Data
Hegstad, Sven Olaf, 1945-Management contracts.
(Industry and finance series, ISSN 0256-2235 ; v. 22)(World Bank technical paper, ISSN 0253-7494 ; no. 65)
Bibliography: p.1. Management contracts. I. Newport, Ian. II. Title.
III. Series. IV. Series: World Bank technical paperno. 65.K891.M35H44 1987 658 87-16059ISBN 0-8213-0924-2
v
ABSTRACT
Management effectiveness is widely recognized as a criticalfactor in determining the performance of enterprises. Many enterpriseowners, whether individuals, private companies or public enterprises, lackthe necessary management skills and technical resources to manage theirbusinesses effeciently and effectively.
The management contract offers a vehicle by which an integratedpackage of management skills, technical and other resources can be ac-quired from one source by the enterprise owner. Ownership is retained butmanagement control is effectively vested in an external manager or mana-gement company possessing the specialized skills required by the owner.Over an agreed period of time, well-defined business objectives can beachieved by this injection of external management skills and the enter-prise enabled to develop a sound internal management base for the future.
The purpose of this paper is to familiarize operational staff inthe World Bank with the main features of management contracts and thedesign issues common to such contracts whatever the sector. While sector-specific issues are important, the cross-sectoral issues addressed in thispaper tend to be universal in character and are of fundamental importanceto the successful development and implementation of management contracts.The paper draws upon a review of 40 contracts from diverse sources andsectors, discussions with individuals and enterprises familiar with theworkings of management contracts, and the limited writings available onthe subject.
Management contracts have become an increasingly common featureof international business in the past 25 years in both industrialized anddeveloping countries. These contracts have their widest application inbusiness operations which are relatively simple or can be easily duplica-ted. They are most common in the. hotel industry and reasonably well knownin health care, agriculture, transportation, certain service industriesand industrial operations such as cement, breweries and textiles. Theyhave also been used (but: less frequently and with mixed results) in largeand complex natural resource projects and manufacturing operations such assteel, integrated textile mills, fertilizers and chemicals.
Four factors are vital to the success of a management contract:(i) there must be a supportive external policy environment; (ii) the busi-ness must be, or have the potential to become, viable; (iii) the owner ofthe enterprise must be convinced that the management contract route is thebest alternative and must fully support it; and (iv) the owner must givethe manager sufficient control and authority to manage the enterprise toachieve the objectives of the contract. The absence of any one of thesefactors makes the chances of success under a management contract remote.
Management contracts are but one option available to enterpriseowners to remedy managerment-related problems. However, their wider appli-cation in the public and private sectors of developing countries has sig-nificant potential if their strengths and limitations are properly under-stood and if the design and business issues inherent in the managementcontract concept are realistically addressed by the parties.
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ACKNOWLEDGEMENTS
This paper owes a particular debt of gratitude to MichaelBrooke, formerly a professor at the University of Manchester, England,who generously provided ideas, comments, and background material fromhis recent publication Selling Management Services Contracts in Ioter-national Business (see bibliography). In addition, Yash Ghai of theUniversity of Warwick, England, gave us the benefit of his own writingson management contracts and made many useful suggestions.
A number of organizations kindly provided details of manage-ment contracts with which they were familiar and special thanks aregiven to the officers and executives of the United Nations Centre onTransnational Corporations, Commonwealth Development Corporation, ArkelInternational Inc., Atkins Planning, Booker Agribusiness Limited,Lafarge Copee Lavalin, Arthur D. Little, and Tootal Textiles Limited.
Within the World Bank, the authors are greatly indebted toAnil Sood, Harinder Kohli, Francis Colaco, and Alberto de Capitani fortheir support and guidance at different stages of preparation. We aremost grateful to Rebecca Candoy-Sekse for her research and writingassistance, to Whitney Watriss for editorial suggestions, and to SusanKellerman for her tremendous help in typing numerous drafts of thispaper. Last but not least, the authors would like to acknowledge thehelpful comments received from Bob Mertz (International Finance Corpor-ation), Elkyn Chaparro, Pierre Guislain, Henry Laurant, Malcolm Rowat,Charles Vuylsteke, Thomas Walde (United Nations Department of TechnicalCooperation and Development) and Anthony Williams.
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TABLE OF CONTENTS
CHAPTER 1. INTRODUCTION AND SUMMARY . .......... ................ . 1
CHAPTER 2. THE NATURE OF MANAGEMENT CONTRACTS .................. 7
2.1 Distinguishing Features .......................... 72.2 Parties to Management Contracts ................. 92.3 Pure Management Contracts ........................ 102.4 Management Contracts Combined with Other
Contract Forms ........ . . . . . . . . . . * . . . * * . * . . . . . * 11
CHAPTER 3. THE USE OF MANAGEMENT CONTRACTS .. oo .............. 13
3.1 Pre-Conditions to Use . ........................... 133.2 Why Use a Management Contract?.................... 153.3 When to Use a Management Contract.................s 193.4 Benefits and Drawbacks of Management Contracts ... 21
CHAPTER 4. MANAGEENT CONTRACTS IN SPECIFIC SECTORS ........... 25
4.1 Tourism/Hot:els .................................... 264.2 Agriculture/Agro-Industries ...................... 274.3 Public Utilities/Service Industries....,,,,....... 284.4 Industry -. 00- ... ................................. .. 30
CHAPTER 5. DESIGNING THE MANAGEMENT CONTRACT ARRANGEMENT ...... 32
5.1 Factors Influencing Design ....................... 325.2 Defining the Objectives ... 335.3 Evaluating the Costs ............................. 345.4 Choosing the Management Company............... 355.5 Choosing the Management Team ..................... 365.6 Preparing the Contract ........................... 37
CHAPTER 6. COMMON ISSUES IN MANAGEMENT CONTRACTS .............. 38
6.1 General .......................................... 386.2 Scope of Management Role .... ..................... 386.3 Management Authority and Control ...... ............ 406.4 Allocation of Responsibility .... ................. 416.5 Decision-Making and Communication ................ 436.6 Obligations of the Owner ......................... 446.7 Personnel .... 446.8 Training and Sustainability of Improvements....... 456.9 Transfer of Technology ........................... 476.10 Compensation ..... ............. ....... ......... 486.11 Duration .................................. ....... 486.12 Liability and Indemnification .. *.....* ......... 496.13 Other Provisions ................................. 49
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CHAPTER 7. FINANCIAL ARRANG:(ENTS ... ............. ......... 51
7.1 General .......................................... 517.2 Annual Fixed Fee ................................. 527.3 Fixed Fee Plus Costs ............................. 547.4 Percentage Fees .. * .................. ......... 547.5 Commissions o......o..*.... .............. .0 ..... 557.6 Incentive Payments .. ....... .......... ............ 557.7 Performance-Oriented Trends ...................... 56
BIBLIOGRAPHY ................................... 59
CHAPTER 1
INTRODUCTION AND SUMKARY
This Chapter provides an introduction to and summary of the mainfeatures and design issues related to the effective use of management con-tracts. Chapter II discusses their nature, the parties involved and dis-tinguishes them from other contract forms. Chapter III examines why andwhen they may be used and their benefits and drawbacks. Sector-specifichighlights are provided in Chapter IV. Chapter V looks at the structuringof a management contract while Chapter VI outlines some of the more impor-tant features and issues to address in preparing and negotiating such con-tracts. Chapter VII contains a discussion of the various compensationpackages found in management contracts.
The management contract concept is a simple one. A managerassumes responsibility under contract for the management and operationalcontrol of another company and is paid for its management skills.
The manager is normally a company drawn from the same line ofbusiness as the owner's company but can also be an individual or group ofindividuals possessing the specialized skills required by the owner. Thefactor which-distinguishes a management contract from other arrangementsfor management services is that the manager is given contractual authorityby the owner to manage the company, not simply to provide advice or con-sulting services.
The underlying reason for the owner of a business to entrustits management to an unrelated manager is also comparatively simple. Theowner, whether an individual or private company, a government or publicenterprise, lacks the necessary managerial skills and technical resourcesto manage the business efficiently and effectively.
In the classic situation, the owner retains full ownership andprovides the funds necessary to run the business; the manager provides anintegrated package of managerial skills necessary to develop, run or reha-bilitate the business and is compensated under the terms of the managementcontract. However, there are a 'number of varying commercial situationswhere the manager may take an equity position in the owner's enterprise orthe management contract may be combined with a licensing, joint venture orfranchising agreement. In such cases, the manager will have financialinterests over and above the compensation payable under the managementcontract and the relationshLip between owner and manager will be morecomplex.
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Management effectiveness is widely recognized as a criticalfactor in determining the performance of enterprises, whether private orpublic. It is all the more important in the current environment of rapidchanges, intensified competition and increased uncertainty. Managementcontracts are most effective when addressing short-term and predominantlymanagement-related problems. They are but one option open to enterpriseowners to remedy management weaknesses. If management is only one of anumber of long-term entrenched problems, other options are likely to bemore effective.
In both industrialized and developing countries, governmentshave used management contracts to divest management control of ailingpublic enterprises while retaining ownership. In several circumstances,this represents an effective and pragmatic alternative to full privatiza-tion or an intermediate step on the road to privatization of ownership.The use of management contracts in this context may become more common indeveloping countries where private capital is not readily available or isreluctant to acquire troubled or debt-ridden public enterprises.
Management contracts have become an increasingly common featureof international business in the last twenty-five years in many differentcountries. Their use in the private sector of industrialized countrieshas been particularly widespread and they have been an important vehiclefor transferring managerial, corporate and technological skills to enter-prises at all stages of growth and development. In developing countriestheir application and usefulness have sometimes been marred by adverseexperiences or by their use in quite inappropriate circumstances. However,their wider application in the private and public sectors of developingcountries has significant potential if their strengths and limitations areproperly understood.
These contracts have their widest application in business opera-tions which are relatively simple and/or can be easily duplicated. Theyare most common in the hotel industry and reasonably well known in healthcare, agriculture, transportation and certain industrial operations, likecement, breweries and textiles. They have also been used (but less fre-quently and with mixed results) in large and complex natural resource pro-jects and manufacturing operations such as steel, integrated textilemills, fertilizers and chemicals.
They can be found, with varying degrees of frequency and accep-tance, in many African countries, the Middle East, South East Asia andLatin America. They are both employed in and "exported" from Europe andthe United States. Companies from newly industrializing countries such asIndia, Korea and Brazil have operated under management contracts in theMiddle East and Africa. Companies from other industrializing countriescan be expected to play a more prominent role in the future.
In some COMECON countries, management contracts under differingnomenclatures are operating unobtrusively in connection with franchisedservices, construction projects and hotels. In China, there is evidence
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of companies which manage a wide range of activities on behalf of relatedcompanies under arrangements akin to those encompassed under managementcontracts.
The above listing of countries and sectors might carry with itthe implication that management contracts have gained a wide acceptance orconstitute a preferred method of operation. Apart from the hotel industrywhere management contracts have become relatively standard, this is notnecessarily the case. Management contracts are tailored to specific situ-ations; depending upon favourable or adverse individual experience of theparties to a contract, reactions and opinions have been moulded accord-ingly. As a result of this diversity of experience in different count-ries, sectors and enterprises, valid judgements as to their general effec-tiveness are made difficult. A more telling indicator is to discover whatfactors contributed to their success or failure in a given situation andto look across a broad range of sectors and contracts to discover uniformpatterns and common features associated with effective contracts.
Quite apart from determining why and when management contractsshould be used, four principal underlying factors have been identified asvital to the success of a management contract. The absence of any one ofthese factors, if not fatal, makes the chances of success under a manage-ment contract remote. These may be summarized as follows:
o The existence of a supportive external policy environment -management expertise cannot be effective if severe price/tariff distortions or adverse government policies and inter-ference hamper the promotion of efficient enterprises.
o The owner's basic business must be viable - no amount ofmanagerial skill can convert an ill-conceived project orunmarketable business into a successful one.
O The owner of the enterprise must be convinced that themanagement contract route is the optimum alternative andmust be fully supportive of it.
O The owner must give the manager sufficient management controland the authority to manage the enterprise in order toachieve the objectives of the contract.
Assuming these factors are present, why use a management con-tract as opposed to other alternatives and for what distinct purposes?There is no simple answer to the first half of the question other than acareful analysis of the problems faced by the enterprise and the matchingof the most effective option to those problems. For example, a publicenterprise experiencing severe institutional, managerial and technologicalproblems may choose between full divestiture, joint venture, leasing,franchising or a management contract; or it may choose to address thethree problems individualLy by instituting public enterprise reform,employing new management from within its own ranks and entering into tech-
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nology agreements. The choice of one of the solutions ("managementtools") to solve the complex amalgam of problems will depend upon threefactors:
o The perceived or analysed effectiveness of the managementtool.
o The availability of the management tool (which will varybetween countries, sectors and sub-sectors).
O The political acceptability of the management tool.
Acknowledging the variability of the solution imposed by theabove factors, and understanding the dynamics of the different managementtools, is a more realistic approach to the question of "why use a manage-ment contract" than attempting a neat formatting of options against setcircumstances. The important point is to be aware of the range of manage-ment tools available and the need to adapt the most appropriate of thosetools to the specific circumstances of the enterprise in question.Governments will come to different conclusions on the most appropriatemanagement tool because of varying ideology, sense of urgency, degree ofrisk aversion and the relative weight given to financial and other bene-fits as against the political costs. A state-owned cement plant may bedivested in one country, leased out in another or operated equally suc-cessfully under a management contract in a third country. Each alterna-tive might represent the optimum management tool given the circumstancesof each country, sector and enterprise.
The answer to the second half of the question, "for what dis-tinct purposes," is more straight-forward. Various circumstances lendthemselves to the use of a management contract. They may be appropriatewhere:
o The owner of a new enterprise lacks the necessary managerialand technical skills to establish the initial business ofthat enterprise.
o The owner of an existing enterprise wishes to address mana-gerial, technical or financial difficulties through an injec-tion of advanced management and other skills.
o The owner wants to undertake a rehabilitation effort, thebenefits of which can only be derived with improved manager-ial efficiency.
o The benefits of a new or advanced technology cannot beobtained unless management capacity, systems and expertiseare first implanted in the enterprise.
o A government wants to divest a public enterprise but needs toreturn the enterprise to a reasonable level of performance inorder to attract investors.
In each of these cases, the management contract offers a vehicleby which a whole package of managerial skills and related resources can beacquired from one source. Where a management company is employed (whichis the majority of cases), the management team will transfer and adapt tolocal conditions not only their own individual skills but the corporateskills, managerial systems, procedures and "culture" of the managementcompany. However, the owner may decide to "de-package" the requiredinputs, limit the scope of the management contract and use it in conjunc-tion with separate licensing or technology agreements, as the case maybe. Thus a management contract may be the principal vehicle or it mayplay a supporting role in a wider joint venture, licensing or otherarrangement.
The growth of management contracts reflects perceived benefitsand opportunities for owners and managers. For the owner, it allowsretention of ownership and overall policy direction; it provides for aninfusion of managerial and technical expertise and the transfer of techno-logy and corporate skills; it may also allow access to foreign markets,international financing and improved growth opportunities. For the mana-ger, it permits the sale of its managerial, technological and other spe-cialized skills, usually with no equity risk; it is a means of establish-ing or maintaining a presence in a foreign market where foreign directinvestment may not be welcome or is strictly controlled; and there may beprocurement, raw materials or product tie-ins which run parallel with themanagement contract and produce their own financial benefits.
While there are benefits to be gained, this arrangement cancarry with it certain drawbacks. For the owner, there is the loss of day-to-day operational control of the enterprise and the corresponding need tomonitor the performance of the manager and ensure that overall policydirection is maintained. The owner continues to be responsible for injec-ting funds into the enterprise and, depending upon the compensation pack-age agreed, may be faced with significant management costs. For themanager, there are risks such as dependence upon the owner's financialstrength and policy dec:Lsions made by the owner which may affect theviability of the managed enterprise.
The design and structure of the overall management contractarrangement, the relationship to be created and its parameters, arematters which the owner should consider well in advance of negotiationswith a potential manager. Enterprises in both the private and publicsectors of developing countries might usefully consider retaining consul-tants to assist in this process during the pre-negotiation stage. Ananalysis of the problems facing the enterprise will determine the natureand extent of the managerial and other inputs which might be necessary.The setting of objectives which the management contract can realisticallybe expected to achieve will follow. While the potential manager will haveits own commercial motivations (and, in many cases, parallel financialinterests), the determination of clear objectives against which themanager's performance can be judged serves the interests of both parties.
Determining the method of choosing the manager (direct invita-tion or competitive bidding), evaluation and selection are all criticalsteps but should be influenced by design decisions already taken by the
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owner. Thus, the identification of specific problems and the setting ofobjectives might lead the owner to approach directly a company which is anacknowledged leader in its field and whose size, technology and managerialsystems are best suited to assist the owner's enterprise; or they may leadthe owner to look for an individual or group of individuals with generalmanagerial skills and arrange for the required technical or other inputsdirectly from another source.
Once the manager has been identified, the stated objectives willbe discussed as will the owiier's assessment of the likely cost of the man-agement contract. It is preferable for both parties to work from agreedsets of figures so that anticipated revenues and other financial projec-tions form a sound basis for structuring a reasonable compensation packagedesigned to achieve the owner's objectives. The choice of the managementteam is critical and the owner will need to assess the overall suitabilityof the personnel assigned under the contract. To the extent possible,such personnel should be drawn from the manager's own corporate staffwhere a management company is employed.
In spite of the large differences existing among management con-tracts in different sectors, there are features and issues which are com-mon to all management contracts: the owner-manager relationship and therole each party is to play; the scope of the manager's authority and con-trol; the inputs and facilities to be provided by the owner; the processby which decision-making, communications, control and monitoring are to beaccomplished; staffing and personnel issues; training and technologytransfer; the form of compensation package and other related issues. Theresolution of these issues will to a large extent define the parameters ofthe business relationship being created between the owner and manager andwill influence the success of that relationship.
Various compensation packages have been used in different con-tracts - a basic management fee, a fixed fee plus costs, agreed percentageof profits or production, incentive payments, commissions and other non-quantifiable benefits. Apart from the hotel sector where there is compe-tition among established hotel management groups, there are no standardsor market-dictated methods of determining appropriate levels of remunera-tion. This makes it difficult for the owner to assess whether the costwill be commensurate with the benefits. However, a growing number of man-agement contracts in many sectors have included as part of the overallcompensation package, performance-based incentives. A blend of managementfee, agreed cost reimbursement and incentives for performance probablyconstitute the optimum compensation package.
Management contracts can be difficult and time consuming arran-gements to design and structure properly. The more complex the enter-prise, the external environment and range of managerial inputs needed, thegreater will be the effort required by the parties to structure the busi-ness relationship and to reflect their agreement on the various issues inthe contract itself. However, if properly understood and used in appro-priate circumstances, management contracts can be an effective means ofimproving management and management-related aspects of private and publicenterprises.
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CHAPTER 2
ME NATURE OF MANAGENT CONTRACTS
2.1 Distinguishing Features
A management contract provides the ,legal framework for a uniquetype of business relationship in which the owner of an enterprise entruststhe management and operational control of that enterprise to an unrelatedmanager for an agreed period in return for compensation.
The manager is usually a company drawn from the same sector orindustry as the owner's enterprise but can also be an individual with theskills required by the owner. In this paper, the term "manager" coversboth situations but the main focus is on management companies.
Implicit in the classic management contract concept is the sepa-ration of ownership and management. This is not to say that a managementcontractor never takes an equity position in the enterprise it is manag-ing. This is sometimes a requirement of the owner or sometimes the desireof the manager to indicate commitment to the enterprise. In most cases,however, the owner retains full ownership and provides the working capi-tal. The management company provides an integrated package of managerial,technical, financial, marketing and other skills required to develop, runor rehabilitate the enterprise while preparing local personnel to operateit at the end of the contract.
What distinguishes a management contract from other arrange-ments connected with management services is that the incoming managementgroup is given full management control and the authority to manage.There has been a tendency to confuse management contracts with otherarrangements which provide for management services or technical assis-tance. In examining the nature of a management contract it is helpful todistinguish it from those other arrangements.
Under consulting contracts, management assistance agreements orother arrangements where an outside company provides management services,that company normally acts in an advisory capacity but does not have man-agement control or authority. These arrangements are therefore outsidethe scope of this paper.
There is sometimes a blurred distinction between a managementcontract and a contract under which an enterprise brings in an individualchief executive officer or group of specialists in time of crisis. Ifthe individual or group are given full management control and authorityto manage, the contract under which they operate is a management contractin the real sense. If not,, the individual or group acts more in an advi-sory capacity and their -ability to achieve the desired results will
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depend upon the quality of the advice given and the extent to which it isaccepted and implemented by those who do have management control. TheAfrican Management Services Company which is presently being establishedby the Bank's affiliate, IFC, is a good example of a situation whereindividuals possessing general managerial skills will be assigned toclient enterprises under management contracts. Managing rather than advi-sing the client enterprise is the distinguishing feature of all managementcontracts.
Management contracts are often confused with construction orproject management contracts. In different sectors, project managementis an arrangement where the owner of a complex construction projectenters into a contract with a company which undertakes the task of manag-ing and coordinating the design and construction phases of the project.The company engaged does not normally undertake the construction itselfbut sub-contracts it out. The company is, therefore, managing and coordi-nating the development of a physical project for the owner. It is notundertaking responsibility for the management of the underlying businessconnected with that project (i.e. a fertilizer plant or mine) which is thecase in the true management contract situation.
There are also cases in the construction industry where a plantor factory has been constructed under turnkey arrangements. At the endof the construction and commissioning phase, the owner may request thecontractor to run the plant for a number of years, to provide managementfor the newly formed company or to build up marketing. Depending uponthe terms of the agreement, i.e., if management control and authority tomanage are vested in the contractor, this would be a management con-tract. If the contractor is only retained to assist management or toadvise on the technical aspects of plant operation, a fundamentally diffe-rent technical advice or consulting relationship is created.
In some developing countries there is a great deal of sensiti-vity to management contracts for political reasons. Contracts which arepure management contracts are given misleading titles such as "technicalcooperation agreement" or "management assistance agreement." In allthese cases, the distinguishing feature will be whether the managementcompany is given management control of the operation and the authority tomanage.
Equally, some foreign companies are sensitive to "management"contracts because they are worried about legal liability and prefer touse a different nomenclature. Unfortunately, in the process of "white-washing" the true nature of the relationship, some of the--substantiverights, authority and management control which should be vested in themanagement company are eroded or excluded. This undermines the manager'sability to manage effectively, thus defeating the whole purpose of thecontract.
There are many examples of licensing agreements which mayinclude management services such as finance, marketing, production andpersonnel. While they may have some of the characteristics of a manage-
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ment contract, they do not constitute a management contract. Joint ven-ture agreements sometimes include detailed provisions for the managementof the venture by one of the parties but without assigning full manage-ment control of the venture to that party. While many of the managementprovisions may approximate those found in a management contract, therelationship created between the joint venturers is quite different tothat created between an enterprise and management company under a manage-ment contract.
2.2 Parties to Management Contracts
Although the relationship created between the owner of theenterprise and the manager is based upon and governed by a contract, therelationship is essentially a business relationship. Three entities arenormally involved in this business relationship:
o The owner of the enterprise in need of managerial services.
o The manager, which may be an individual but more often a publicor private company from either an industrialized or developingcountry.
O The enterprise itself.
In developing cotntries, the owner will, in a large number ofcases, be a government and the enterprise a state-owned enterprise. How-ever, private companies can equally benefit from an injection of externalmanagement expertise and the more progressive private companies in develo-ping countries may increasingly seek this form of assistance. The managermight be a local company if the enterprise is located in one of the newlyindustrializing countries or in a country with a reasonably developedprivate sector. In many cases the manager will be a foreign company whichis either in the business of providing management services overseas orwhich has been specificallyr approached by the owner to manage the enter-prise because it possesses unique managerial or technical expertise ofrelevance to the owner.
The management contract itself may be between the owner and themanager or between the enterprise and the manager. Normally, governmentsdo not enter into management contracts although there are examples wherea ministry is sometimes designated as the government party. Where theenterprise to be managed is a public enterprise, that enterprise would bethe party to the contract.
A management company which contracts with a public enterprisewill be dealing not only wtth the existing management of that enterprisebut also with the government, government officials and government repre-sentatives on the Board of Directors. It is therefore the total busi-ness relationship which should be taken into account, not merely the rela-tionship established between the two parties to the contract.
While there will only be two parties to the contract itself,the triangular owner/enterprise/manager relationship is important toremember. In the private sector and especially the public sector, each of
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these entities has quite different perspectives, motives and objectives.Unless all three are understood and accommodated the management contractwill run into trouble.
2.3 Pure Management Contracts
In the classic management contract situation, the owner normallyprovides the equity and other working capital inputs while the managersupplies the management and technical skills.
The manager is primarily interested in selling an agreed rangeof management and other services and receiving a fee or some other form ofcompensation for its efforts. The owner's principal objective is toobtain the benefits of those management skills (for the least cost) with-out bringing the manager into an equity position. This arrangement may becalled a pure management contract situation i.e. the management contractarrangement stands alone and is the only basis for the business relation-ship between the owner and the manager.
This "pure" contract is mostly found in the agricultural sector,in public utilities and the transport sector and in many of the hotel man-agement arrangements. The following are but a few examples: Transmark(the consulting and management arm of British Rail) manages and operates anational rail system (or a specific part of a system) in several countriesa fee being the only form of remuneration. Commonwealth DevelopmentCorporation manages government-owned plantations and estates in a numberof countries in return for a fee plus costs. The U.S.-based Health CareAssociates undertakes the management and operation of privately andpublicly-owned hospitals in a wide range of countries and derives itsincome solely through an agreed financial formula without any ownershipstake. These are all pure management contracts where management servicesalone are being bought and sold.
Many situations in which management contracts are used are notquite so basic and simple. The management company might provide someequity and derive part of its income not only from the fee but also fromdividends. It might have a buyer-customer relationship with the enter-prise (i.e., it might buy or sell its raw materials or products) andderive additional income from commissions on purchases or sales. It mighthave a technical assistance agreement with the enterprise and receive aseparate fee for these technical services. There may be a joint venturearrangement, a franchise agreement or licensing arrangement with theenterprise which needs the additional support or input of advanced manage-ment and technical expertise. In designing and structuring a managementcontract arrangement, the owner should be aware of such parallel financialinterests and motivations and ensure that they do not interfere with theachievement of the objectives under the management contract.
Wherever the management contract ceases to be "pure" in thesense described above and other commercial/financial interests are invol-ved, the fundamental relationship between the parties will be different
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and the motives and aspirations of the parties may diverge. The differ-ent contract forms commonly associated with management contracts arebriefly examined in the next sub-section.
2.4 Management Contracts Combined with Other Contract Forms
Management contracts are often found in conjunction with tech-nical assistance agreements. Even though the management contract willusually provide for the transfer of management, technical and otherskills, there may be highly specialized or proprietary technical matterswhich can best be dealt wiLth under a separate agreement. In this case,the management contract is supportive of the technical assistance agree-ment in the sense that the technical services cannot be properly providedand adopted by the enterprise unless the managerial capacity exists toabsorb the technology.
The management company receives separate remuneration under thetechnical assistance agreement over and above whatever compensation pack-age may have been negotiated under the management contract. The manage-ment contract in conjunction with a technical assistance agreement isfound in most sectors, particularly in the agricultural sector and manyareas of the manufacturing sector.
Management contracts are also combined with licensing, techno-logy and franchising agreements in order to complement the licensed tech-nology or the franchise with the expertise to use it. Licensing involvesthe exchange of technical information by transferring patented technologyor know-how in return for a fee. Under franchising arrangements, thefranchisor possesses a proven business concept which he places at the dis-posal of the franchisee. Licensing or franchising assumes that the licen-see or franchisee has the managerial and other business skills plus thecapital to use the licensed technology or to run the franchised businessprofitably. This is largeLy the case in industrialized countries but notnecessarily so in many developing countries. In this latter situation, a,separate management contract might accompany the licence or franchiseeither from the outset or when the licensee or franchisee begins to exper-ience serious difficulties. Licence agreements and franchise agreementsmight contain provisions for technical or even managerial assistance forinitial periods of operation but this does not, from a legal stand point,convert them into management contracts as such. In practice, however,distinctions can become blurred and if the amount of managerial and tech-nical help required by the licensee or franchisee becomes significant, aseparate management contract might be entered into by the parties.
Joint ventures atre frequently accompanied by management con-tracts. While this is more common in the private sector than in thepublic sector, the effect is the same. one of the joint venture partiesis given full management responsibilities for the company or operation inquestion. The party entrusted with management may possess particularskills or, where their industry experience and managerial skills areroughly the same, the joint venturers may simply decide that one of theparties should manage the company or operation.
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This latter case is frequently found in mining joint venturesin the private sector. In the public sector, where a state-owned enter-prise is in joint venture with a private company, the private companymight demand full management control iD order to protect its equity posi-tion and to ensure that the operation is tightly controlled in allrespects. This frequently happens where private companies have faced a"localisation" program and have had to reduce a majority position to aminority equity holding. The case of Lonrho and the Assante gold fieldsin Ghana is a case in point as is Falconbridge in the Dominican Republic.In both situations, the private company saw the need to protect its mino-rity position through management control under a separate managementarrangement.
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CHAPTER 3
THE. USE OF MANAUEMENT CONTRACTS
3.1 Pre-Conditions to Use
Before examining why and when a management contract should beused, there are certain fundamental factors which must be present, regard-less of country or sector, if the arrangement is to work effectively.
A management contract encompasses a business relationship whichis subject to all the factors that customarily influence business develop-ment. Like any other business arrangement, if the prevailing external orinternal conditions affecting the management contract are unfavourable,its chances of success are reduced. Although the pre-conditions for theiruse may seem obvious when outlined, a surprising number of enterprises andmanagers have proceeded to their detriment without a thorough examinationof those conditions.
In discussions with a number of management companies, consultinggroups and individuals who have had experience of operating ventures undermanagement contracts, four factors kept recurring as being essential pre-conditions to use. While the absence of any one of the pre-conditionswould not necessarily prove fatal, the task of managing the enterprise ismade considerably more difficult and the management skills injected ren-dered less effective.
First and foremost, the basic business of the enterprise must beviable. If the owner's business is declining or facing difficultiesbecause it is essentially non-viable, neither a management contract norany related management services arrangement will cure that situation. Itmay help to solve temporary management-related problems but not inherentbusiness deficiencies. In this respect, an enterprise owner needs to con-duct an analysis of the problems encountered by the enterprise to identifywhether they are capable of resolution through the vehicle of a managementcontract. An enterprise whose markets are declining or whose product haslow acceptability might trace these problems to weak or inefficient mana-gerial systems, poor marketing or production skills. Equally, they mightbe traced to more fundamental market conditions which will persist howeverstrong management might become.
Second, the external environment has a profound effect upon theefficiency and effectiveness of any enterprise. A manager will farelittle better than the existing management of an enterprise if it isexpected to operate in an adverse business environment. If the enterpriseis subject, for example, to price controls, tariffs, import restrictions
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or has poor foreign exchange access, the benefits of a management contractare unlikely to be recognized. In the public sector, the problems can bemore acute if there is direct government interference in the enterpriseand social and other politically-influenced objectives take priority overcommercial considerations."
A recent report prepared by the Bank's affiliate, IFC, assessedthe potential demand for management and related services among commer-cially operated public enterprises in Sub-Saharan Africa. It identifiedcountries in which "the environment is already favorable for independentbusiness management or which are in the process of introducing structuraladjustment programs containing broad macro-economic reforms and rationali-zation of the public enterprise sector as part of the process to improvethe business environment." The need to ensure that the overall businessenvironment is conducive to a management contract arrangement is tan-tamount and recognized as a precursor to a successful management opera-tion. Some management companies operating in the public sector haveentered into direct accords and understandings with governments on basicbusiness conditions (prices, foreign exchange access, lifting of importrestrictions) prior to signing management contracts with a public enter-prise. This practice is not as yet widespread but is likely to becomemore common in the future. :
Third, the owner of the enterprise must be convinced that themanagement contract route is the optimum solution and be fully supportiveof it. Cases were cited of management contracts being made a condition offinancing or presented as the only solution without consideration ofalternatives. As the relationship between owner and manager and theirrespective personnel lies at the base of the arrangement, a non-supportiveowner or an alienated incumbent management will present major difficultiesfor the incoming manager. However well written the contract may be, therelationship which underlies it must be sound and both owner and managerwilling to understand and accommodate the often conflicting interests,motives and objectives which they possess.
Fourth, but very much related to the third point, the owner mustbe willing to delegate to the manager sufficient management control andauthority to permit the manager to run the day to day operations of theenterprise and realise the objectives set by the contract. In one sensethis is not so much a pre-condition as an implementary requirement. Onthe other hand, the owner will need to determine during the planning andpre-negotiation stage the parameters of the manager's authority and theextent to which it intends to confine itself to the overall policy direc-tion of the enterprise. The objectives set by the owner must be capableof achievement by the manager and its authority and control in some mea-sure related to the tasks it is expected to perform. Several contractswere reviewed where ambitious objectives were specified but quite restric-ted management powers and authority granted. This is a contentious issuein both the private and public sectors but possibly more difficult toreconcile where a public enterprise is involved.
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3.2 Why Use a Management Contract?
The competitive environment and complexities of running anenterprise efficiently present owners with a continuous series of businessproblems. An analysis of the full range of those problems is beyond thescope of this study. However, at the risk of over-simplification andwithout attempting to be exhaustive, some typical problems can be classi-fied in three groups according to magnitude and complexity.
First, discrete problems related to strategy, organization,systems and procedures. These could include choosing between two largeinvestment projects, diversifying a product line, strengthening the R & Deffort, introducing a new accounting system, changing marketing strategy,finding working capital or reorganizing the computer department. Second,specific problems of a more fundamental nature: weak or deficient manage-ment; inefficient or non-competitive technology; outdated and ineffectivesystems and procedures. In the case of a public enterprise, there mightbe the added institutional problems inherent in the relationship with thegovernment. Third, complex problems which might be an amalgam of problemsof the type just mentioned.
An analysis of the problems facing an enterprise is the startingpoint in determining what an appropriate solution might be to remedy thoseproblems. A management contract is but one option open to enterpriseowners to remedy management weaknesses. Any enterprise which is consider-ing the use of a management contract has to be reasonably confident thatit is the best means of addressing and resolving the problems which itfaces. The first question which arises, therefore, is "why use a manage-ment contract? What are the alternatives?"
The first set of discrete problems mentioned above are mostly ofa short term nature and can typically be solved by internal personnel and/or by external management or technical consultants. The central problemsare not management-related.
If the problems are of a more fundamental or complex nature(i.e. those mentioned in the second and third categories above), more com-prehensive and penetrating solutions are required. A public enterprisemay be experiencing severe institutional, managerial and technologicalproblems. In theory, the government has an array of solutions ("manage-ment tools") available to it. It may choose to address the three problemsindividually by instituting public enterprise reform, employing new man-agement and establishing technology agreements.
If the above problems are partly management-related, the degreeof the management problem will help to decide whether a less comprehensivesolution than a management contract will suffice. This can be more clear-ly demonstrated by a public enterprise example where a number of lessermeasures might be considered before resorting to a management contract:
o There may be experienced and talented local managers and techni-cal personnel available in other areas of government or in theprivate sector who are able to make sound contributions--provi-ded that the management deficiencies are not too severe and thatskilled technical and other personnel are not so reduced in
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numbers as to be ineffective. In order to attract such localskills, the government would need to offer a competitive compen-sation package and other incentives. Unfortunately, manygovernments are reluctant to take such an enlightened step.
o Another alternative within the government's power is to reducethe government "pressures" which make management of the enter-prise difficult, if not impossible, whatever the calibre ofexisting management. Government interference, lack of manage-ment autonomy, public sector procedures and pay scales, lack ofincentives, pressures to maintain depressed price levels orlarge numbers of staff at uneconomic levels all combine toproduce a "management" problem of the government's own creation.
o If the management problem is identified simply as a somewhatreduced level of local managerial and technical skills and pro-vided that the problems are not too severe, it may be possibleto engage consultants to advise and assist management and toprovide technical and other assistance where necessary. Theemployment of consultants who have no executive or managerialstanding, assumes that a reasonable management structure andlevel of competence is in place and that advice and assistanceis sufficient to overcome the problems.
If, as is likely, the problems are intertwined and not capableof individual solution, more comprehensive solutions have to be consi-dered. These include full divestiture, joint venture, leasing, franchis-ing or undertaking a management contract. These different managementtools (solutions) may address the main problem areas more or less effec-tively depending upon the circumstances. Table 1 on the next page shows insimple terms examples of the different problem areas which certain manage-ment tools might be expected to tackle. It will be seen that some can onlyaddress individual problems while others are stronger in two or more areas.
Given the number of variables in each case, it is impossible tostate in precise terms which solution fits which problem. However, a moreimportant point to note is that not every management tool may be availablein a particular situation. The actual choice of management tool willdepend upon three factors:
o The effectiveness of the management tool.
o The availability of the management tool, (a factor which willvary between sub-sectors and countries).
o The political acceptability of the management tool.
Each of these inhibiting factors is briefly examined below.
Effectiveness. The effectiveness of individual management toolswill depend in part upon their comparative advantage vis-a-vis each other.For example, if an enterprise's problem is both management and technology,then inherently a management contract is better than just hiring new man-agement. If the problem is technology and public enterprise institutional
Table 1: MNANAGEFMr PROBLEW AND SOLUrIONS
managemint Problem
Exaples ofDiscrete Problems Fundamental Problems
Solved on Project Basis Requiring Hbre Penanmet Solution
Build Discrete Weak Technology, PE- Co8ENTSMnagement Tools (Solutions) New Strategic Operational Manage- Systems & Institutional
Plant Direction Problems ment Procedures Problems
1. Management ConsultantsDiscrete problems that
2. Technical Consultants can be solved on aproject basis.
3. Turnkey Project Management
4. Public Enterprise Reform Spe problemst of amore fundamental nature
5. Technology/Licensing Agreements that require a morepermanent solution.
6. New Management
7. Management Contract * *
8. Franchising * *** * Complex problems causedby several factors which
9. Leasing *** *** *** require fundamental
changes in ownership10. Joint Venture *** *** and/or operational
approach.11. Full Divestiture *** ***
= This management tool is typically best suited to address this problem.* = This management tool can also contribute to solving of this problem.
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relationships, then a franchising option or joint venture are likely to bebetter than a management contract. If all three problems exist, fulldivestiture will, in most cases, be the best alternative. However, ifthere is a lack of high quality private investors, a better alternativemay be the leasing of facilities/assets or a management contract. In addi-tion, effectiveness will also depend upon the strength of the managerialand technological skills supporting the particular tool. While a jointventure arrangement might offer certain advantages over a management con-tract (i.e. the joint venture partner may be willing to provide capital),a proven management company which is a leader in its field might be moreeffective in solving the problems faced by the enterprise than an untestedjoint venture partner with more funds than experience.
Availability. One solution may be analysed as being the mosteffective in the circumstances but may not be available. Divestiture maynot be viable if there is no developed private sector or if the enterpriseis essentially unattractive to private investors. Similarly, joint ven-ture and leasing may be discounted because of the poor financial positionof the enterprise or the physical state of the enterprise's facilities.
Acceptability. When the owner is the state, political acceptabi-lity becomes an important consideration. For example, full divestituremight address all the major problems faced by a public enterprise but theleasing of facilities and the retention of ownership may be perceived as amore acceptable alternative by the government. In a situation where apublic enterprise is facing severe institutional, technical and managerialproblems the most efficient solutions, in order of priority, might be fulldivestiture, joint venture, leasing, franchising and management con-tracts. In terms of political acceptability, the order might be complete-ly reversed. Acceptability will vary between countries and sectors andbetween enterprises in a sector or sub-sector. Factors influencing accep-tability of a management tool include government ideology towards privati-zation, the visibility and size of the enterprise, potential unemploymentproblems and identity of prospective private sector purchasers. A govern-ment which favours state ownership of a particular enterprise might, forexample, rank the management tools in the following order:
Management Tool Government Ownership and Control
1. Management Contract Ownership of enterpriseControl of policy
2. Franchising Ownership of enterpriseControl of policy and management
3. Leasing Ownership of assets
4. Joint Venture Part-ownership of enterprisePartial control of management andpolicy
5. Full Divestiture No ownership interestsNo controls
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Governments trying to remedy the severe institutional, techno-logical and managerial problems facing public enterprises must search forsolutions that consider effectiveness, availability and acceptability andalso weigh the financial and other benefits against the political costs ofchange. Governments will reach these decisions differently because ofdifferences in ideology, perception of urgency and degree of risk aver-sion. A state-owned cement plant may be divested in one country, theassets leased out in another country and operated by a management contrac-tor in a third country. There is no contradiction in this state ofaffairs and no proof that one solution is more successful than another.It is merely illustrative of the varying situations and problems in diffe-rent countries, sectors and enterprises and the variety of solutions whichcan prove to be effective, available or acceptable in those situations.
3.3 When to Use a Management Contract
Experience has shown that management contracts are most effec-tive when addressing predominantly management-related problems. Weak man-agement permeates all areas of a business or operation and can give riseto problems from production right through to marketing. Appropriate man-agerial inputs in identified weak areas, combined with technical or otherresources, can resolve a wide range of corporate, financial, technical,administrative and marketLng difficulties which are traceable to manage-rial deficiencies.
A management contract provides a vehicle for transferring anintegrated package of skills covering the managerial spectrum. The mana-gement company can normally provide not only the managerial and technolo-gical skills required to meet the specific difficulties facing the enter-prise but also effect a transfer of its corporate "culture" and provenindustrial experience. Included in this would be its own managementsystems and procedures, corporate planning techniques and overall manage-ment style and philosophy. What is being sold is its ability to run abusiness combined with specific and advanced knowledge of the particularindustry or sub-sector in which the owner's enterprise is located. These"lcorporate" aspects are not present when an individual or a group of indi-viduals is engaged as manager; but their general managerial abilities andexperience in operating successful enterprises lies at the heart of thedecision to engage them under a management contract.
If this aspect of a management contract is clearly understood,the circumstances in which such a contract can be effectively used aremore easily discernible. Management contracts are often used as vehiclesfor training, for technology transfer and for other purposes but theseshould be subsidiary to the main focus on management. If training ortechnology are the prime interests of an owner, these can be accomplishedunder separate programs or agreements without need for a full managementcontract. Similarly, if management deficiencies are the reasons for enga-ging the manager, conditions must be such that its management skills canbe fully utilized. Imposing internal enterprise constraints by limitingits managerial authority and control; or permitting external conditions tofrustrate its managerial initiatives run counter to the whole rationaleunderlying the arrangement.
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Experience has also shown that management contracts can be usedmost effectively in business operations which are relatively straightfor-ward and/or easily duplicated. For example, management companies whichhave managed hotels, medium-sized manufacturing operations, transportoperations, health care inputs, agri-businesses etc., have been able toeffect significant turnarounds in similar operations in a wide variety ofcountries if the problems are principally management-related and the tech-nical inputs within their specialized area of expertise. When the enter-prise and the problems are more complex and the variety of factors affect-ing the enterprise more diverse, the management focus may become divertedand the manager's task made more difficult.
In general, management contracts are used less frequently thanother management tools mentioned above. Management contracts materializeas good second or third best solutions under the following circumstances:
o Where the government is owner and divestiture is not consideredto be a politically acceptable alternative.
o The enterprise is facing fundamental problems regarding bothmanagement and technology.
o The inherent business is relatively simple and the manager'ssystems and skills can be transferred from another location andduplicated in the owner's enterprise.
o The value added to the enterprise by the manager in terms ofmanagement, corporate culture (i.e. systems, procedures, con-cepts and skills) and/or technology are high enough to justifythe costs.
o When the number and variability of risk factors related to theeconomic policy environment and the owner-enterprise-managerrelationship are not allowed to grow too complex.
At the risk of oversimplification, where the principal objectiveis to ensure ultimate managerial efficiency in its widest sense (i.e. todevelop local management's ability to manage all aspects of an enterpriseand to achieve a viable commercial operation), then a management contractis probably the most appropriate method of achieving that objective. Itis a temporary and intermediate step on the path t,o the enterprise's over-all viability.
The circumstances in which an enterprise might entertain theabove objective will vary but several distinct situations can beenvisaged:
o Where the owner of a newly established enterprise or projectfeels that there is insufficient local expertise available toestablish and run the new enterprise or project in the initialphase.
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o Where an enterprise faces severe managerial technical and finan-cial difficulties and wishes to regain profitability in order tocontinue trading under upgraded and better trained local person-nel.
o Where an enterprise wishes to undertake the rehabilitation of aproject or operation which is its principal source of businessand decides that the benefits of such rehabilitation can only bederived if its local managerial capacity and efficiency are alsoincreased.
o Where a government wants to divest a state-owned enterprise butmust first return it to a reasonable level of performanceattractive to private investment.
o Where the benefits of a new or advanced technology, process orother resource cannot be achieved without external managementcapacity, systems and technical expertise to introduce and adaptthe resource to local conditions.
From the above it will be appreciated that the use of managementcontracts is not confined to any one situation but there are a number offactors which will determine their successful use. The analysis of pro-blems faced by the particular enterprise and consideration of the variousoptions available to solve those problems is an essential prerequisite toany decision to use a management contract.
3.4 Benefits and Drawbacks of Management Contracts
Any management contract will carry with it certain benefits anddrawbacks for the parties involved. The perception of these by the ownerand the manager will depend upon their respective objectives and commer-cial motivations. In addition, potentially unfavorable aspects can bereduced or eliminated during negotiations. Given the variables betweendifferent contract situations, countries and industries, it is not helpfulto be too dogmatic about benefits and drawbacks. Table 2 on the next pagehighlights the more obv:Lous pros and cons of management contracts.
The major benefit for the owner is that the management contractroute permits it to retain ownership. This may be a dominant considera-tion in the minds of some governments and may explain why this option hasbeen more politically attractive in many cases than direct local orforeign investment or entering into joint ventures. It also allows thegovernment to solve its managerial and resource deficiencies by obtainingthe most suitable managerial expertise and influencing both its scope anduse by means of the management contract.
On the manager's side, the benefits are several. Its financialcommitment relative to its return will be minimal, particularly where itis not required to make an equity investment. It will receive an agreedincome flow through the management fee and can probably earn additionalbonuses based upon such variables as performance, sales or other agreed
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Table 2
MANAGEMENT CONTRACTS: BENEFITS AND DRAWBACKS
Owner Benefits Drawbacks
Allows ownership retention. Loss of day to day opera-tional control.
Provides managerial and technical Management fee generallyexpertise. payable regardless of
profitabilityOverall policy directionmaintained. Owner remains responsible
for all operating expensesTechnology transfer which includes and debt servicing.training and transfer of managementand corporate skills. More expensive than other
options.
Access to new markets and Time consuming and complexinternational financing. to structure properly.
Greater profit potential in the Possible drain on enter-long run due to improved management prise's foreign exchangeand technical efficiency. supplies.
Manager
Agreed income flow via management Financial risk iffee. prevented from earning
performance payments.Compensation for service, usuallywith no equity risk. Dependence on owner's
financial strength.Means of establishing new markets.
Lack of control in policyMaintain presence in foreign market, areas.especially in countries inhospitableto direct investment. Lack of control over
"external" factors such asPossible procurement, raw material, government interference,and product tie-ins. policies etc.
Device to adapt commercial strategies Risk of early contractto changes in international market termination.place.
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criteria. The manager may also gain access to the markets of anothercountry, access to primary resources, commission on procurement and otherpecuniary or strategic advantages, depending upon the terms of thecontract.
The drawbacks for the owner and manager may be summarized asfollows:
Owner
o The owner gives up control of day-to-day management and opera-tions, although ultimate policy and budgetary control are nor-mally retained.
o The management fee or some substantial element of it may be pay-able regardless of the profitability of the enterprise or theperformance of the manager. The owner must therefore be convin-ced that the enterprise will be able to generate additionalincome to cover the management fee and any other compensationpayable.
o The owner bears the full risk of any shortfalls in income rela-tive to operating expenses and debt payments. Unlike a leasesituation, the owner is not receiving any fixed rental.
o Management contracts are time-consuming and can be expensive toimplement, both absolutely and relative to other options. (Ifsuccessfully implemented, the long-term gain generally justifiesthe resources and the investment furthers the long-term develop-ment of the country's managerial and technological base).
Manager
o The financial risk is low in comparison with that under leasedor joint venture operations. If the business is operating belowits break-even point, the owner, not the manager, must make upthe cash deficits. However, if the business is operating aboveits break-even point, the management company may realize a lowerreturn than it would under alternative arrangements. In effect,the management company gives up some potential profit for lessrisk and investment.
o The management company is reliant on the owner's ability to pro-vide long-term infusions of financing when the cash flow isinadequate to meet operating, debt servicing and management feeexpenses.
o Unless the management company has equity in the enterprise, ithas minimal influence on decisions regarding the sale or dispo-sition of the business and on major policy decisions affectingthe direction of the enterprise.
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The advantage of attempting to analyse the owner's or managementcompany's respective positions in terms of drawbacks is that it allowseither party to attempt some diminution of the same during the negotiatingprocess. For each one of the potential drawbacks mentioned above, a con-tractual provision can be agreed which will have the effect of minimizing(or even removing) what might have been an unacceptably high risk if notidentified as such and openly discussed in those terms during negotia-tions.
For example, on the owner's side, loss of day to day control bythe manager is a seemingly profound "disadvantage" and leaves it at themercy of the manager. It will be seen later in Section 6 that the ownercan impose workable checks and balances on that day to day control in theform of reserving certain major decisions for its prior review; requiringconsultation on other matters (i.e., recruitment and promotion); estab-lishing a sound communications and reporting system on agreed matters; andhaving the capacity to monitor the management company's performance.
The problem connected with payment of a management fee irrespec-tive of performance can, in most situations, be minimized by reducing thepure fee element and linking the bulk of the compensation package to per-formance/profitability-related criteria.
on the manager's side, there can be a similar diminution ofdrawbacks in most areas but some areas do continue to present quite highlevels of risk whatever the contractual provisions. The owner's policydecisions, its financial resources, access to foreign exchange, and possi-ble influence by government in the case of a state-owned enterprise, areall matters which the management company has to take into account inassessing the overall risk and the minimum compensation which it mustreceive to run that risk.
This last point is more often than not misunderstood by govern-ment. There is a tendency to equate management contracts with consultingcontracts and to cost them in the same manner. The fact is that a manage-ment contract is quite distinct from a consulting contract both in sub-stance, the nature of the responsibilities undertaken, the risk elementand the relationship created. It is therefore a more complex and expen-sive proposition than a consultancy.
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CHAPTER 4
MANAGEMENT COWTRACTS IN SPECIFIC SECTORS
Management contracts have become an increasingly common featureof business management during the last twenty-five years. The economicsectors in which management contracts have been commonly used are summar-ized in the Table below. For a wider treatment of the different sectorsin which management contracts are used, reference should be made to Dr.Brooke's book (described in the bibliography) upon which parts of thisChapter are based.
Table 3
GENERAL USE OF MANAGEMENT CONTRACTS IN DIFFERENT ECONOMIC SECTORS
Agriculture Industry Transport Public Utility Services Tourism
Agriculture Mining/ Airlines Gas Banking HotelMineral AirportsProcessing Bus-lines
Agri-business Manufactur- Road Water Insurance TravelSugar plan- ing freight servicestations
FertilizerDairy pro- Textiles Rail Electricity Retailingducts ChemicalsCattle farm- Food Shipping Posting processing
Machinetool
Irrigation manufac- Cargo Telecommunica-systems turing handling tions
Furnituremanufac-turingCement Port Health carebreweries manage-
ment
Petroleumprocessing;/refiningand dis-
tribution_
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4.1 Tourism/Hotels
Management contracts have found their widest application in thetourism/hotel industry, where they have become standardized in the sensethat an accepted format and reasonably uniform provisions have evolved.They grew rapidly in the United States during the '50s and '60s and tour-ist growth overseas led to their use in many developing countries. Theybecame the preferred arrangement in these countries because internationalhotel groups could expand rapidly with low financial risk in areas wherethe investment climate was perceived to be somewhat unstable. Unlike theextractive industries and complex manufacturing enterprises, ownership wasnot felt to be vital to control an individual operation or to transfer andmaintain a business concept.
Most international hotel management contracts specify a widerange of management services: the integrated package includes operationalmanagement, financial control, accounting, a complete training program atall staff levels, and specialized services such as purchasing and world-wide marketing. The management company supplies experienced personnelfor senior management and supervisory positions and has carefully definedpowers with respect to personnel, their quality being vital.
The management fees payable under hotel management contracts inmost cases conform to a certain pattern. The reason is that the intensecompetition between hotel management chains allows owners to shop aroundand compare standard packages, a luxury not available to the same extentin other sectors. The management fees may be calculated as a flat rate(more common in earlier domestic United States/European contracts), butmore frequently as a percentage of turnover or profits, or based on amixed formula.
Given the prevalence of hotel management contracts and the cons-tant refining of their financial provisions in a highly competitive envi-ronment, they are a useful guide to possible approaches to structuringfinancial packages for management contracts in other sectors. Certain ofthe principles hammered out in hotel contracts (full management control,specific management powers and responsibilities, no interference by theowner except in defined circumstances, control of personnel, and a well-defined compensation structure), are applicable to other sectors in spiteof the obvious sectoral differences.
One feature of hotel management contracts that is somewhat uni-que is their duration--10 to 20 years, with options to renew on the sameor similar terms for further periods of 5 to 10 years. Internationalhotel chains insist on long contracts not only for financial reasons, butalso to ensure that their corporate operating philosophy and systems arefully absorbed and that their reputation is safeguarded.
There is considerable variation in hotel management contractswhen it comes to equity holdings. In many cases the management companydoes not acquire an equity position, but in some developing countries thegovernment may specify that it do so. Generally where an equity positionis taken, some specific circumstances will have led to that step.
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In recent years, management contracts have been negotiated insuch countries as Egypt (by Brent Walkers), Sudan (Ramada), Tunisia(Trusthouse Forte) and Zambia (Caledonian Hotel Management). The Inter-continental International hotel chain alone has management contracts in anumber of African countries including the Ivory Coast, Central AfricanRepublic, Zaire, Gabon, Zambia, Liberia and Kenya. In all these casesthey have proved to be politically acceptable and commercially successfulfor both owner and management company. Several countries have had adverseexperiences but many of the problems encountered can be traced back toinappropriate use or undue government interference in the hotel operation.
4.2 Agriculture/Agro-Industries
Agriculture is the second major sector in which management con-tracts are used although not nearly as extensively as in the hotel indus-try. Dr. Brooke has observed that the link between technological innova-tion and management skills is as close in agriculture as in any otherindustry sector. Planning, timing, stock control, storage, marketing andthe correct use of chemical and mechanical aids--and the need to coordi-nate the activities of disparate groups of farmers--are all required toensure that plantation, forestry, sugar, rubber or oil palm undertakingsare efficient producers.
Some management contracts arose as a result of the nationaliza-tion of plantations but their growth has tended to be in support of estab-lishing an individual plantation or rehabilitating an existing one. Theyhave also grown up in conjunction with technical assistance agreements andlicensing agreements, lending crucial management support to the technicalactivities. As was noted earlier, many examples of pure management con-tracts can be found in the agricultural sector but advanced tehnologicalinputs have equally led to the need for more advanced management skills.Management contracts have played a support role in these situations.
The nature of many agricultural projects is such that managementcompanies do not find it an attractive proposition to take up equity; andin some developing countries, governments are reluctant to permit foreignownership of basic agricultural activities. While no statistics have beencollected in this area, a review of agricultural management contracts byDr. Brooke in African countries shows that several countries seem to haveencouraged a minority equity holding by management companies--i.e., Zambia(tobacco and sugar), the Ivory Coast (rubber) and, in one contract, Malawi(sugar). In other African countries such as Swaziland (sugar), Ghana (oilpalm), Nigeria (sugar), Tanzania (tea), Kenya (furfural and sugar) andMalawi (tobacco, coffee and sugar) equity holdings by the management com-panies were usually below five percent.
Modern plantation development calls for a high level of manage-rial and technical skills which are not readily available in the develop-ing countries of Latin America, Africa and South East Asia. In addition,a series of foreign inputs may be required in the form of fertilizers,seeds, machinery, finance, marketing and knowledge of commodity markets.This array of inputs, technical skills and overall management are supplied
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by a number of international companies which have experience in verticallyintegrated operations from primary production to international sale.
While the owner of the plantation will usually own the land,plantation facilities and machinery, the terms of the contract may callfor the management company to supply fertilizers, advanced machinery andeven finance for the same. While processing facilities will normally beowned by the domestic enterprise, the later stages of the process--bulkstorage, shipping, insurance, further processing, wholesaling and retail-ing may fall within the scope of the management company's responsibilitiesand to a large extent will be handled by the relevant departments of themanagement company's head office.
From the plantation owner's point of view, management contractssolve many problems. Among them are lack of experience in modern techni-ques of cultivation, seed development and harvesting as well as the inabi-lity to provide adequate training. Both Booker International Inc., amajor agricultural management company operating in many parts of the worldand the U.K.-based Commonwealth Development Corporation, indicated thatkey problems which their management responsibilities were designed toassist were the lack of (or failure to keep) accurate data on productionand harvesting operations, inability to estimate output volumes and thusto balance capacity with inputs at different stages of production, proces-sing and marketing. In addition, a number of external factors such asweather, natural disasters and fluctuations in commodity markets call fora level of planning, coordination and control which can be supplied byinternational management companies.
Management contracts reviewed for the purposes of this study inthe agricultural sector covered arrangements between the Government ofJamaica and a U.K. company for the operation of sugar factories, proposalsfor the external management of agricultural estates in Sao Tome andPrincipe and arrangements for a complex sugar refining project in Sudanmanaged by a U.S. based company. All three contracts contained markeddifferences in approach and in the compensation structures designed toachieve specified objectives.
4.3 Public Utilities/Service Industries
In many developing and industrialized countries, public utili-ties such as gas, water, electricity, telecommunications and health careare in the public sector. A wide range of transport services--air, seaand land--are also part of the public sector.
Many of these state-owned public utilities have experiencedsevere managerial and financial problems in recent years. In some deve-loping countries, the management corps in key public utilities has dwin-dled as good managers are attracted to the private sector at home or over-seas. In others, inefficient, poorly trained and poorly motivated mana-gers, deficient management, planning and control systems, low levels oftechnology and government pressures to maintain jobs and prices ratherthan to operate on a sound commercial basis, have led to a serious declinein public utility services and financial performance.
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A special feature of management contracts with public utilitiesis that management services are often provided by the management/consul-tancy arm of counterpart utilities in other countries. Public companiesin Britain, France, Canada, Australia, India and other countries competeto provide management services to public utilities in developing coun-tries, often with the active support of governments wishing to promotetheir own trading interests.
The duration of management contracts in the public utilitiessector is often short--two or three years. Fees are often calculated ona cost-plus basis, the main component being expatriate salaries. Con-tracts usually call for a high level of expatriate personnel for a concen-trated period, technology transfer and systems adaptation. More than mostother sectors, management contracts come hand in hand with high levels ofequipment supplies, usually from the management company's own country, andthe fees may be quite subsidiary to the higher and more strategic benefitswhich accompany equipment supply.
In the transport sector, management contracts can be found inroad passenger, road freiLght, rail, air, shipping, cargo handling andport activities, whether publicly or privately owned. As with public uti-lities, the state-owned transport systems are not usually open for invest-ment. Thus, management contracts tend to be of the pure variety, withshort durations and a cost plus compensation scheme. Once again, nationaltransport companies from foreign countries tend to predominate -- espe-cially in the rail and air transport sectors. For many years, the Indianrailway administration managed the Nigerian railway system, Aer Lingusmanaged Zambia Airways, KLM managed Garuda and the Ghanaian shipping linewas managed by an Israeli navigation company. British Rail (under itsinternational subsidiary, Transmark) are operating in Africa, the Far Eastand Latin America as are a number of other state-owned British enterprisesin the airline and airline-related sectors.
In France, many municipal authorities contract out the supply ofservices to private firms and there are a number of examples of managementcontracts for the operations of treatment plants, sewage disposal, watersupply and waste collection. A well-known example in a developing countryis that of Societe de Dist:ribution D'eaux de la Cote d'Ivoire (SODECI) bywhich the water and sewerage services of the Ivory Coast are managed. Itsfee structure is cost-plus and is indexed against inflation. The ventureis the only water supply company in West Africa to possess its own train-ing centre. The services are of high quality and paid for by the con-sumers who pay a variable tariff to keep down the cost to the poor.
A number of international telecommunications companies have beenactive in seeking opportunities to develop and manage telecommunicationsystems in developing countries, mainly as a means of selling their tech-nology and equipment. However, companies such as British Telecom, Cable& Wireless and several Canadian companies see management contracts as abusiness in their own right. The proposed privatization of the Sri Lankantelecommunications system (on which the Bank has been advising) may dependno a large extent upon a management contract to be negotiated between the
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proposed Sri Lanka Telecommunications Company and an international tele-communications company. The latter would supply the requisite managementand technological skills during an initial period of about five years andwould ensure that a management organization, systems and technical capabi-lities are built up.
The growth of contracts in the health care sector has beenextremely rapid. A number of international companies (some linked topharmaceutical companies but most concentrating on management aspects)have specialized in the design, equipping and management of hospitals,specialized health-care facilities and other medical enterprises. Manyother companies (operating principally out of the United States andEurope) have negotiated management contracts in the Middle East, withmilitary hospitals or with facilities for large industrial complexes con-nected with mineral extraction, refining and processing. Such contractsare very difficult to obtain probably because this has become a highlycompetitive area and contractual terms are sensitive. One U.S. basedcompany, HCA Management Company, delivers health care to more than 400hospitals in the United States owned or managed by HCA or its subsidiariesand operates under management contracts in seven foreign countries.
4.4 Industry
The use of management contracts in the industrial sector is notso widespread as in the hotel and agricultural sectors but there are stillmany examples in both industrialized and developing countries. There is agrowing tendency to employ them in conjunction with technical assistance,licensing and other technology/know-how transfer arrangements. Thereappear to be increasing numbers in basic manufacturing industries such astextiles, food processing, fertilizers and chemicals. In each case theyare closely tailored to highly individual circumstances and no pattern oruniform set of provisions can be discerned.
Examples of management contracts are found in the mining indus-try but many of these are the result of management control being main-tained under contract after nationalization, the retention of managementcontrol after reducing an equity position, or management control in sup-port of a joint venture. They are invariably complex arrangements andvery much tied to the achievement of the foreign mining company's corpor-ate and strategic objectives. The Bank's only experience of managementcontracts in the mining sector has been the Mano River Project in Liberiaand the recently negotiated management contract between State Gold MinesCorporation (SGMC) of Ghana and a Canadian mining group for the rehabili-tation of three of SGMC's gold mines.
A number of management contracts in the mining sector werereviewed for the purposes of this paper. There were most significantvariations in their terms and approach to different issues, merely illus-trating the fact that they were negotiated in entirely different circum-stances and in varying socio-political and market conditions. A number ofmining joint ventures combining management contract arrangements were inoperation during the late '60s and early '70s in Zaire, Zambia, Ghana andSierra Leone but copies could not be obtained.
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In the petroleum sector, their use has been limited (and veryinfrequent) to the management of oil refinery operations or as part of thearrangements for the overall operations of a petroleum-related complex.One contract reviewed was for the INDENI petroleum refinery in Zambiawhich was managed by Agip Petroli of Italy. Another was connected withthe construction and management of gas facilities in the United ArabEmirates.
Management contracts are frequently cited as being connectedwith oil and gas drilling and exploration ventures but these are inessence operating agreements under which one of the joint venture partiesundertakes responsibility for the management of the exploration program ordrilling activities.
Manufacturing operations connected with management contractshave not been confined to the larger industries. Many small manufacturershave engaged companies under management contracts with highly beneficialresults. A number of case studies have been conducted on Swedish com-panies which have operated in African and Middle East countries and thesuccess rate has been high in such diverse activities as boat building,explosives, pulp and paper and chemical plants.
Management contracts have been employed in heavy engineering andsteel-making projects, aluminum plants and smelters and rubber and glassplants. The incidence in these areas is not limited to developing coun-tries and a number of companies in industrialized countries have employedindustry leaders with proven records and high technological capabilitieseither to assist in the commencement of a new industrial operation or torevamp an old one.
Manufacturing industries, especially those where new technologyor advanced management systems are required in order to remain competi-tive, have used management contracts in recent years. Existing manufac-turing enterprises which have declined both in terms of available manage-rial skills and financial performance have sought foreign managementexpertise to assist in rehabilitation programs. In Sri Lanka, the govern-ment undertook an extensive rehabilitation program for some of its textilemills and brought in Indian and British companies under management con-tract arrangements.
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CHAPTER 5
DESIGNING THE MANA:ENAG ?I CONTRACT RANGEKEET
5.1 Factors Influencing Design
The design and structuring of the overall management contractarrangement needs to be considered by the owner well in advance of nego-tiations with a potential manager. The pre-negotiation phase encompassesa number of steps, each of which will have an impact on the ultimate via-bility of the management arrangements and the relationship to be createdbetween the owner and manager.
Commencing with an analysis of the enterprise's problems, theowner will determine whether the management contract route is appropriateand, if so, the nature and extent of the managerial and other inputs whichmight be necessary. The business objectives of the contract have then tobe considered i.e. what is the manager expected to achieve during the termof its management role and the medium/long term position of the enterprisethereafter. Once the broad objectives have been determined, the ownermust estimate the possible cost of the contract to ensure that it is afinancially viable solution. Decisions can then be taken on the charac-teristics and qualifications of the manager to be engaged (whether a com-pany or an individual).
A number of companies and consulting groups which have had expe-rience of the management contract process have identified the pre-negotia-tion phase as critical and probably one to which many owners pay inade-quate attention, especially in the public sector. In many cases, consid-eration of design features and issues stemming therefrom do not take placeuntil negotiations. At that stage, the manager may have presented a draftcontract for consideration. Ideally, the draft contract should reflectthe owner'gs basic thinking and judgements on different design features.This will not occur if the pre-negotiation phase has been omitted or ina-dequately utilized. The consideration of a number of key factors duringthe design stage will have an influence on the structure of both the rela-tionship and the contract. These factors can include the following:
o The possible need for consultants to assist the owner in thedesign stage. This will depend upon the owner's capabilitiesand experience in this area. Public enterprises in developingcountries with little or no experience of the management con-tract process would be well advised to consider engaging limitedconsulting services for this purpose.
o Detailed analysis of the problems facing the enterprise andpriority ranking of those problems to determine appropriatemanagerial and other inputs.
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o Evaluation of tbhe external environment and determination whethermanager's inputs will be unduly prejudiced by that environment.Where the owner is the government, this is an area which can beinfluenced and tempered by the government.
o Realistic assessment of whether the owner and existing manage-ment team will be fully supportive of the proposed managementarrangement.
o Determination of the medium and long-term business objectives tobe achieved by the proposed contract and plans for sustainingthe improvements and management efficiency gained thereby.
O Intended scope of the management role and degree of authorityand control to be vested in prospective manager.
O Evaluation of possible cost of the contract and its impact uponfinancial position of the enterprise.
o Desirable characteristics of manager and determination of bestapproach to engagement (direct or tendering).
The remaining sections look at several of the more importantsteps and factors mentioned above in the design stage.
5.2 DefiDing the Objectives
Management contracts have to accommodate a wide range of differ-ing and often conflicting, motives, objectives and interests. The successof the business relationship will depend heavily on the extent to whichthe parties identify the differences, actual or potential, prior to nego-tiations, compromise on them during negotiations, and accommodate themduring implementation. Management contracts have often failed because theparties themselves have failed to recognize or understand each other'squite different motives and expectations.
The underlying motivations of the parties will probably not bediscussed explicitly durLng negotiations but will manifest themselves inthe setting of objectives, the strategies designed to achieve those objec-tives and in delineating areas of particular concern in the contract pro-visions. In setting objectives, the owner should attempt to understandthe commercial motives of the management company. Where the owner is agovernment, the political/social motives of the owner should be taken intoaccount by the management company. Any lack of understanding as to thetrue objectives of the contract, the expectations of the other party orthe real dynamics of the owner-manager relationship either before or dur-ing the negotiations, will inevitably cause problems during the implemen-tation of the contract.
The starting point with any management contract must be thedefinition of objectives--what does the owner want to accomplish? Theanswer to that question will not only determine whether the managementcontract is the appropriate tool, but will govern the choice of manager
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and the general structure of the contract. The objectives will help deli-neate the general nature of the contractual relationship to be created;the roles to be assigned to each party; the authority and control the man-ager will have to be given for it to achieve the owner's objectives; thespecific managerial or other skills to be acquired; the duration of thecontract; the nature of the assistance or facilities the owner needs toprovide; the staffing pattern; and the compensation package that will bestinduce the manager to achieve the stated objectives.
The prospective manager will also have certain objectives. Itwill want to sell as wide a range of management and other skills as possi-ble on the best terms. In addition, it might want to gain access to mar-kets, or take up a minority equity position in the enterprise to assurecontinued access. Another objective might be to establish a buyer-cus-tomer relationship with the enterprise and buy its raw materials or sellthe manager's own products to the enterprise.
Very few of the management contracts reviewed set out in clearterms the objectives to be achieved by the contract. This probably stemsfrom a failure on the part of the owner to formulate fully the preciseobjectives rather than the draftsman omitting them from the contract.The setting of clear objectives at an early stage of the pre-negotiationphase is an essential pre-requisite to the whole management contractprocess.
It is interesting to note the comments and insights of severalconsulting groups who have assisted a number of governments and state-owned enterprises to identify and select suitable management companies forprojects in different parts of the world. Both groups made the commentthat governments, in approaching a management contract situation, havetended to adopt an essentially short-term, profit-motivated approach.They did not place the management contract in the context of a long rangebusiness plan for the enterprise or determine how improvements in theenterprise were to be sustained at the end of the contract. In otherwords, they failed to set either medium or long term objectives whichcould be achieved through the management contract process and to determinethe precise direction of the enterprise after the termination of thecontract.
In this context, the use of consultants may be considered tocarry out the necessary examination of the enterprise, the problems whichit faces, the short, medium and long term business objectives which couldbe achieved by the management contract and the financial and economiccosts of the same. Such consultants could also be involved in the selec-tion process for the manager and advise the government or enterprise dur-ing negotiations.
5.3 EValuating the Costs
With the identification of problems, required managerial andother inputs and the setting of overall objectives for the contract, theowner is faced with the question of the possible cost of the proposedarrangements.
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The owner needs to determine whether a management contract isaffordable, given the likely cash flow of the enterprise and its otherresources. The owner will continue to be responsible for the capital andoperating expenses, debt servicing and other outgoings of the business.Depending upon the nature and extent of the problems, estimates can bemade of the likely management personnel costs, the management fee and suchother compensation elements as incentive payments, commissions, productionor sales bonuses, etc. These costs have also to be borne by the enter-prise and should be factored into financial projections to discoverwhether the enterprise can generate sufficient revenues to accommodatethese additional costs. Equally, the estimated benefits to be derivedfrom the contract in terms of increased production, sales or other crite-ria, should be made part of the overall financial analysis.
Apart from a straight financial analysis, the owner may look atexternal factors which may affect the manager's estimate of cost eitherpositively or negatively. On the negative side, if external factors haveled to the current unprofitable position of the enterprise, the managermay be reluctant to undertake the contract without a high management feeelement. Similarly, if political risks are perceived to be high, the man-ager may want those risks to be reflected in its fee. On the positiveside, the owner may investigate whether there are special conditions whichmay make the overall management assignment more attractive i.e. access toraw materials, domestic markets, sale of the manager's products/technologyto the enterprise, procurement benefits, etc. Quite often these areequally beneficial and attractive to the manager as the contract compensa-tion.
By undertaking the above analysis, the owner will be able toform initial ideas on the likely form of the compensation package and thetype of manager which might be interested in undertaking the proposedarrangement. While these ideas have still to be tested during negotia-tions, the design and planning process combined with the evaluation oflikely costs will place the owner in a sound position at the outset ofnegotiations. The owner will, in effect, be laying down the parametersand defining the main elements of the proposed relationship. These willbe modified during the course of negotiation but cost proposals by themanager can be balanced against the owner's own estimates. In thisrespect, the preparation of financial statements which can be agreed withthe prospective manager during negotiations is important. Both partiesshould be working from a set of figures and financial data in which theyhave confidence and which can serve as a proper basis for their respectivefinancial projections.
5.4 Choosing the Management Company
The choice of manager can either lead to a beneficial contribu-tion to the owner's business if the relationship and contract are allowedto function well; or to a worsening position if the business and contrac-tual arrangements fail. Depending upon the scale of the problems and sizeof the enterprise, the owner will have to determine whether an individualor individuals can undertake the contract or whether a management company
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should be approached. Management companies are usually drawn from thesame industry as the enterprise. Some international companies regardmanagement contracts as a business in their own right and openly markettheir services. Others are known to be leaders in their field and areapproached by the owner directly.
It is not possible to draw up criteria capable of meeting allsituations and the industry in question will significantly influence thetype of management company sought and chosen. The owner's objectives (ifclearly formulated) will provide some indication of the likely character-istics of the management company--large or small; world-wide interests orrestricted to one country or region; an established record in a particularindustry; the possession of specific expertise; or qualities which aredirectly relevant to the owner's business.
Depending upon country and owner characteristics, there may notbe a wide choice of companies. Even when tenders are invited, there maybe only one or two responsive bidders. An international competitive bid-ding process may attract those companies which are in the business of pro-viding management services. A systematic prequalification process basedupon the owner's objectives, medium and long term business aspirations andother factors is more likely to unearth a suitable short list of candi-dates. If consultants are involved in the process and the objectives andother owner/country characteristics are matched with a foreign company orcompanies after a comparative survey, there may well be merit in permit-ting a direct approach.
5.5 Choosing the MHnagement Team
However exacting the provisions of the contract may be, thecontract will not work if the personnel provided by the management companyare not of the highest quality. The following characteristics have beenidentified in personnel assigned under successful contracts: a high levelof competence in their particular discipline; the ability to translateexpertise into practice in exacting circumstances; ability to communicateeffectively with managers of a different cultural background; ability toadapt the management company's "corporate culture," business concepts,skills, systems and procedures to local conditions; and to create enduringsystems, not systems which can only be understood and maintained by themanagement company's personnel.
The management team should normally be drawn from the contrac-tor's own corporate staff and should be accustomed to working as a cohe-sive team. one of the principal purposes of a management contract is totransfer the company's corporate skills and knowledge and this can only bedone through the company's own personnel who are imbued with the "ethos"of their corporation. This feature would not be present when an indivi-dual is engaged but, even in this case, the individual's managerial skillswould be based upon knowledge of systems and procedures in other enter-prises and transferred accordingly.
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The process for recruiting personnel under a management contractis completely different to that of recruiting consultants. First and foremost, a corporation is being recruited with the specific objective ofobtaining an internal team which is equipped, both professionally and per-sonally, to undertake the management tasks encompassed in the contract.In a sense, the owner is buying a "slice" of the management company.Recruitment of personnel outside the corporation has the effect of dilut-ing the team and increases ithe chances of failure in an already difficultsituation. Only specialists who are not available internally are normallyrecruited externally.
The use of the contractor's own personnel has a further benefitfor the owner. Such personnel will be guaranteed a job to return to with-in the organization. Retention (and probably enhancement) of promotionprospects, together with pension and other rights, will also be guaran-teed. This element of job security means that the manager in the field isnot looking for opportunities to extend the contract and thereby theemployment of the management company's team.
One example which is worth quoting in this context is the recentmanagement contract negotiated for a mining operation in Ghana. Duringthe evaluation stage it was noted that several bidders had included largenumbers of personnel drawn from outside their own organization. In onecase, a large and well known company had simply gathered together all thepersonnel required from outside, the project manager being the exception.This perhaps indicates that some major companies are not familiar with theactual workings and requirements of management contracts and also that theowner should be alert to this problem at the evaluation stage.
5.6 Preparing the Contract
The contract form which serves as the basis for negotiations isusually provided by the management company in those sectors where manage-ment contracts are used extensively. Its provisions tend to favor themanagement company's position--the hotel industry being a prime example.
In the industrial sector, enterprises and projects are substan-tially more complex and the management company will not necessarily be inthe business of providing management services on a regular basis. Theowner, having formulated its objectives, undertaken the necessary studiesand financial evaluation, will in all likelihood be in a better positionto draw up the management contract as the basis for negotiations.
In the overall financing of a project, it would be most advanta-geous to make provision for legal assistance to draft a management con-tract which encompasses the owner's objectives and its position on the keyissues. While the owner's initial (and optimum) position in the draftcontract will be modified during the negotiating process, at least themain principles and elements which the owner feels are essential forachieving its objectives will be embodied in the draft.
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CELAPTER 6
COMMON ISSUES IN MHNA&ENET CONTRACTS
6.1 General
The terms and conditions of management contracts are specificto the country, industry and enterprise to which they relate. In certainsectors - the hotel sector being the prime example - there are standardfeatures and provisions which are used industry-wide. In most other sec-tors, terms and conditions vary widely as do the size, content and formatof management contracts.
Notwithstanding this diversity, a number of issues are commonto all management contracts: the owner-manager relationship and the roleeach party is to play; the scope of the manager's authority and control;the obligations of the owner; the process by which decision-making, commu-nications, control and monitoring are to be accomplished; staffing andpersonnel issues; training and the transfer of skills and technology; thecompensation package; the liability of the parties; settlement of dis-putes; duration of the contract; and several other related issues.
Each of these issues needs to be considered and resolved by theparties at an early stage in the planning and negotiating process. Al-though ultimately reflected in the contract, they are not issues whichshould only be considered when confronted with a draft contract. They arepart and parcel of the business relationship which is being created. Themanner in which they are resolved will define the parameters of that rela-tionship. These issues should, therefore, be considered in the context ofestablishing a workable relationship, with the contract providing the spe-cific framework and mechanisms necessary to achieve the objectives of theparties.
The issues mentioned above are by no means exhaustive and thediscussion which follows is only intended to highlight some of the differ-ent ways in which these issues have been handled.
6.2 Scope of Management Role
The precise scope of the manager's role and the responsibilitiesundertaken must be clearly defined in the contract.
Many contracts merely state that the management company willconduct the business affairs of the enterprise in an efficient and profit-able manner without specifying the parameters of the management role andthis invariably leads to problems at the implementation stage. Owners orthe incumbent management group sometimes wish to leave unclear the truelimits of the management company's role and responsibilities in the beliefthat they will retain more control or management power. This attitude
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causes conflict during implementation and is quite counter-productive.The management company has no accurate perception of what is required ofit; and the owner has in effect failed to decide upon the objectives ofthe contract and the specific content of the management role required toachieve those objectives.
In general, the following activities and responsibilities mightbe included within the scope of the management company's role: generalmanagement (overall corporate planning, organization and personnel plan-ning); financial administration (planning, budgeting, financial analysis,borrowings, liquid assets control and accounting); personnel administra-tion; production management and provision of technical know-how; trainingof local staff in systems, procedures and specific management and opera-tional functions; marketing and distribution (depending upon the type ofenterprise); and such other matters as may be included in the scope of themanagement role specific to the industry and enterprise.
The scope of the management role must be commensurate with theobjectives which the manager is expected to attain. If the manager is tobe responsible for turning around an unprofitable mining operation oragri-business, the scope of its role cannot be confined to purely techni-cal areas. Achieving higher production or outputs might be possiblethrough a purely technical role. Turning around a business and beingaccountable for profitability demands a far wider role for the manager.Those inputs which the manager must realistically make in order to achievethe owner's desired objective must help to determine the scope of themanager's role and its attendant responsibilities.
An example can be taken from a contract which was recently nego-tiated in Ghana. The manager was required to manage the rehabilitation ofthree mines for a state-owned mining enterprise, the prime objective beingthe return of the enterprise to a profitable situation. Under the termsof the contract, the manager was responsible for the planning, managementand supervision of mining operations, geological services, mining ser-vices, metallurgical services and specific rehabilitation projects. Theseareas might be characterized as technical in nature. However, on the non-technical side, a wide range of activities fell within the scope of themanagement role, namely, accounting, financial control, procurement, per-sonnel, office administration, communications, design and implementationof training programs, formulation and implementation of sales policy andeven financing assistance. The parties had accurately identified theareas in which the manager would have to make an input (in the absence oflocal management personnel) if both the operational and commercial objec-tives were to be achieved. In doing so, the scope of the management rolefor the particular situation faced by the Ghanaian mining enterprise wasdefined and reflected in the contract.
The nature of the problems faced by the enterprise will alsohave a bearing on the scope of the management role. In some situationsthere may be a need for concentrated technical services or technologytransfer with an associated but limited managerial function to ensureproper adaptation and incorporation into the enterprise's business. In
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such a case, the management contract might provide a specific and limitedmanagerial role, with the technical services or technology transfer separ-ated out under a parallel technical assistance or licensing agreement.Owners quite often attempt to "de-package" the management skills requiredand to provide for specific inputs under accompanying licensing, marketingor technical agreements. While the scope of the management role may varywidely from contract to contract the need to link scope with ultimateobjectives remains true in all cases.
6.3 Management Authority and Control
If the manager is to be given the responsibilities outlined inthe contract, it must equally be given the management authority and con-trol required to fulfill those responsibilities. This is one of the mostdifficult areas to negotiate in a management contract and yet it is cru-cial that it be realistically and equitably negotiated. The problem ofmanagement authority and control is often stated in terms of a conflict ofinterests--the owner wishing to retain as much control as possible overthe operation; and the manager requesting full authority to undertake allthe activities and responsiblities which it feels are prudent and neces-sary to operate a commercial enterprise. While in one sense there is aconflict of interests, it is not necessarily useful to examine the problemin those terms.
What is happening is an agreed allocation of management author-ity and control--the delineation of the day to day management powers whichthe management company must have if it is to run the domestic enterprise.It is quite distinct from the overall policy direction and the right toreview and approve major financial and operational matters in respect ofwhich the owner quite justifiably seeks to retain a degree of control. Ifthe manager is to be held accountable for the performance of its responsi-bilities, the "lack of authority" excuse often raised by managers whenthere has been a failure to perform should not be a defence made availableby the owner itself.
In a growing number of contracts, a list of specific powers andareas of responsibility are provided for, these being powers which themanager sees as crucial to the fulfillment of its management functions.Equally, it is usually specified that the Board of Directors of the enter-prise will have responsibility for the overall policy direction of thecompany and that certain major matters will be subject to final Boardreview and approval.
Among the key management powers will be found, for example, con-trol of the owner's personnel, including hiring and firing, promotion andlayoff; the planning and design elements of the particular project or pro-duction process; control of production schedules, procurement and mainte-nance programs, and preparation of annual work programs and accompanyingbudgets. Among the matters subject to the owner's approval are criticalmatters such as approval of work programs, capital and operating budgets,expenditures in excess of amounts provided in budgets; and proposed con-tracts in excess of an agreed amount.
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The manager must be given sufficient management and day to dayoperational control to rtn the enterprise and owner "interference" mustbe limited to defined circumstances. Although the word "interference"will almost never be found in management contracts in the industrial sec-tor, in hotel management contracts there is usually a standard undertakingthat the owner will not interfere in the manager's day to day managementof the hotel. In an area such as the hotel industry where management con-tracts have been extensively used and refined, the irony of bringing in anexternal party to manage and then not permitting it to manage was learnedat an early stage. The management powers found in hotel management con-tracts are far wider than in any other sector and would probably representan unacceptable level of control in most other sectors. For example, onehotel contract (with a major international hotel chain) provided that "theManager shall have absolute control and discretion in the operation of theHotel."
One contract reviewed was between the Jamaican Government and aU.K. management company for the operation of sugar factories and canesugar estates. The objectives of the contract were clearly stated and theduties of the manager comprehensively documented. The grant of managementpowers and authority was directly linked to the performance of thoseduties and is a good example of management powers being made commensuratewith the responsibilities undertaken by the manager and with the achieve-ment of specified objectives.
6.4 Allocation of Responsibility
The threefold nature of the business relationship (owner, mana-ger and enterprise) requires a number of organizational decisions and aclear allocation of responsibility for the various tasks set forth in thecontract.
The Board's role will normally be restricted to overall control,broad policy direction and the review and approval of matters specificallyreserved to it in the contract. The separate Board-management roles whichhave become familiar in many industrialized countries are not so estab-lished in developing countries and there are many instances, especially inpublic enterprises, where the Board exercises powers and exerts controlover management functions. A management contract cannot afford to leavethe respective roles of Board and management vague.
One internationial management company concerned with the provi-sion of management and technical services to major agro-industrial con-cerns in many parts of the world, has drawn up a "preferred" contract formbased upon its long experience of management contracts. Throughout thecontract, the allocation of responsibility as between Board and manager isclearly spelt out. The manager's appointment is for the "management ofthe whole of (enterprise's) business and undertaking for a period of(seven) years." Subject to the overall direction of the Board, the mana-ger's specific responsibilities are outlined. The precise relationshipbetween the Board and manager is also specified: the Board will determinethe overall policy of thle enterprise and "the manager will be responsible
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for the day to day implementation of operations within the agreed policy."The Board designates one of its members to liaise with the manager in allmatters of policy and the manager's representative is invited to attendall meetings of the Board.
The principle of overall Board direction of the enterprise isusually stated but without prejudice to the specific management powersgiven to the manager and its control and management of day to day businessoperations. If the manager's duties are clearly and comprehensively setforth, there is less chance of arguments over "grey" areas. By specifi-cally excluding from the manager's duties and attendant powers thosematters which only the Board can decide, the Board's residual management-related powers can be defined. For example, the manager may be given noauthority to borrow money on behalf of the enterprise; to sell or other-wise dispose of the enterprise's unmoveable property; to invest the enter-prise's monies (save for short term deposits); to commit to expendituresbeyond those approved in budgets; to create mortgages or liens; and toenter into contracts unrelated to the specific operation or in excess of astated amount.
Where the manager holds no equity in the enterprise (as in apure management contract) there is no direct representation on the Board.However, in such cases there is usually a provision made in the contractfor the manager to be present at Board meetings in order to be made awareof general policy matters and to present reports on the enterprise's oper-ations. The precise reasons for the manager's presence will be outlinedin the contract.
If the manager does hold equity in the enterprise, direct Boardrepresentation may be demanded (whatever the shareholding) but votingpowers would be proportional to that shareholding. In these circum-stances, the manager is likely to have a more influential voice on theBoard, even if the shareholding is small, by reason of representing ashareholder and by reason of his control of day to day operations.
Where a Chief Executive of the enterprise remains in place(i.e., the manager's representative does not have a direct reporting rela-tionship to the Board), particular care has to be taken in the contractand in the organizational structure to ensure that the allocation of res-ponsibilities is clearly understood and that staff at all levels alsounderstand the reporting lines.
Several cases have been cited of a strong Chief Executive under-mining the manager, countermanding operational decisions well within themanager's authority and, in effect, ignoring the new management relation-ship and the fundamental basis of the management contract. While the con-tract cannot prevent this happening (unless the manager determines thatthe contract has become impossible to perform and has grounds for termina-tion),the proper examination of the issue at negotiations and a clearunderstanding of the manager's role may help to prepare the way for easierimplementation. Other contracts were reviewed where all managementactions were "subject to the prior concurrence of the Board" or "subject
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to the approval of the Board's designated representative." This formulta-tion in effect usurps the management role and cannot be expected to workwell in practice. It merely indicates that the owner has not accepted theprinciple of external management.
The allocation of responsibility between Board, Chief Executive(if there is one), the manager and the management company itself will bemade somewhat more complex when dealing with a state-owned enterprise.This brings into play yet another level, namely, that of government.While not a party to the contract, the government and the ministry oragency responsible for the enterprise will have a vested interest in theprogress of the contract and may wish to become involved. This is one ofthe more difficult aspects to deal with during negotiations but it shouldbe tackled; and government representation, coordination and communicationsshould be encompassed to the extent possible in the contract.
6.5 Decision-Making and Communication
The manner in which the decision-making process and lines ofcommunication between the parties are established should follow andreflect the control, authority and allocation of responsibility linesdiscussed in earlier subsections.
Contracts are often silent on these matters. It may be thatthese are matters which are ultimately worked out in practice. However,the management contract should provide the overall framework within whichthe parties will operate. During the negotiation process the means where-by the parties will arrive at decisions, the communication of those deci-sions and any special bodies (i.e., technical committees, Board sub-committees, coordination committees or groups) which may facilitate thedecision-making and coordination process should be discussed and formali-zed in the contract.
The contract can call for a series of different reports andinformation flows from the manager. These might include technical, opera-tional, financial, progress or other reports which are either informa-tional or specifically designed to elicit a decision from the Board on aspecific matter. The more comprehensive the reporting system and agreedcommunication channels between the Board and manager, the more smoothlythe contract can be expected to work. If procedures agreed are found tobe unsatisfactory in practice or need to be modified during the course ofthe contract, the parties can agree to this.
If there is a specific area of concern i.e. procurement, market-ing, technical matters, etc. where either the Board or manager feels thatspecial decision-making processes should be established, these should beprovided for in the contract. In many public enterprises, procurement orthe consideration of teclnical recommendations by the manager may becomebottlenecks. Board-appointed procurement, technical or other specialistcommittees with full delegated powers and manager representation have beensuccessfully used to cut through unnecessary or time consuming internalprocedures.
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6.6 Obligations of the Owner
In the context of operations in developing countries, an owneris always required in the management contract to facilitate certain acti-vities of the manager.
In one contract reviewed, the owner undertook to supply to themanagement company, without charge, agreed facilities, information, dataand assistance in obtaining work permits, provision of housing, officespace, transportation, and communication facilities. Some of the mostimportant areas from a management company's viewpoint can be the obtainingof import licences, approval to open bank accounts, clearances throughcustoms, export permits, and liaison with government departments.
The extent to which the owner honors these obligations will sig-nificantly affect the outcome of the contract, especially in countrieswhere government procedures are the cause of extensive delays in equipmentprocurement and clearances for imports and exports. The management com-pany is engaged to tackle the managerial and technical problems of an en-terprise. It must receive assistance from the owner or enterprise in theareas mentioned above if it is to function efficiently and effectively.If there have been significant problems for the enterprise in the past,these should be discussed with the management company. The nature of theassistance to be provided by the enterprise (and by government whereappropriate) should be clearly spelt out in the provisions relating to theowner's obligations. Several management companies have taken the addedprecaution of obtaining direct government assurances on basic conditionsand provision of facilities when dealing with public enterprises. Whilethis is by no means a standard practice, companies with experience in thisarea are reluctant to enter into contracts without direct assurances fromgovernment.
In a Jamaican contract, a detailed set of conditions precedentwere set by the manager and had to be fulfilled by the government (owner)for the management phase to become operational. These included the ownerbringing into effect a plan for the severance of personnel in excess ofthose required by the enterprise; the provision to the enterprise of fundssufficient to finance working capital, to pay for imported goods and ser-vices and to pay manager's fees, all as set out in the agreed initial bud-get for the first year of operation; and the approval of special exchangecontrol facilities required for the operation of the enterprise and forpayments to the manager and non-resident suppliers.
6.7 Personnel
In taking over the management and day-to-day control of theenterprise, the incoming manager will not only be providing its own quali-fied personnel to fill agreed managerial, administrative and operationalpositions, but will become responsible for the direction of the owner'spersonnel at all levels. The exact situation will differ from contract tocontract but most contracts will attempt to provide for the manner in
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which the management company's personnel will integrate into an existingstructure and the control and authority which the management company'srepresentative will exercise over the enterprise's personnel.
In the case of a state-owned enterprise, the problems connectedwith personnel, staffing policies and the right to hire and fire will beunduly difficult. However, without the right to exert control over localpersonnel, the management company will not be in a position to manageeffectively. In situations where overstaffing is problematical, the man-agement company might insist that the enterprise take action to reduce thework force before the contract commences (i.e. in the Jamaican examplecited above).
The management company will attempt to secure the right to hireand fire, but workable arrangements can also be agreed to allow for con-sultation on recruitment, promotion and other areas where the Board of theenterprise had an obvious long term interest. The principle of day to daycontrol over local personnel is especially important on the operationalside where effective recruitment, dismissal and promotion controls aredirectly related to the overall efficiency of the enterprise. The manage-ment company's own personnel will normally be subject to prior approval bythe owner. They may be removed for cause at the owner's request andreplacements similarly approved by the owner.
A sensible formulation employed in many of the management con-tracts reviewed was to give the manager power to appoint and, if neces-sary, dismiss staff, agree terms and conditions of service and promotionand generally deal with all matters relating to the enterprise's employeesin accordance with the laws of the particular country. Provided that allemployee relations are conducted within the framework of the local laborlaws, the manager should not be otherwise fettered. Hotel contractsalmost invariably give the manager control over labor policies (includingwage rates, the hiring and discharging of employees in accordance withlocal laws) as the quality and efficiency of staff has a direct andobvious bearing on the hotel's profits.
6.8 Training and Sustainability of Improvements
From the owner's viewpoint, the training of local personnel tofill key management and operational positions, thereby ensuring a viable,locally managed enterprise at the conclusion of the management contract,is normally an important objective. The management company is oftenrequired to undertake training programs, on-the-job training, overseastraining in the management company's productive facilities (if applicable)and compensation may or may not cover the training element.
In a number of contracts reviewed, the management company wasrequired to carry out an agreed training plan for the training of localpersonnel at all levels, including technical and management levels. Thestated intention of such a plan was progressively to replace expatriatesat all levels in accordance with an agreed localization timetable. The
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manner in which the training provisions are structured vary considerablyfrom sector to sector but are a relatively uniform feature of managementcontracts, whatever the sector.
A number of management companies have encountered considerabledifficulties with the training component under their contracts. Whiletheir personnel are professionally equipped to carry out the managementtask, training skills are not necessarily highly developed. If trainingof local personnel is a key objective of the owner, careful considerationshould be given to permitting a sub-contract for the training componentunder the overall supervision of the management company. In this fashion,specific training skills can be injected and blended with the managementcompany's specific areas of expertise. Where a management company posses-ses an independent training capacity, this may not be necessary.
The formulation of suitable provisions to cover training is anarea of especial difficulty for the draftsman. A number of contractsreviewed left the question open (i.e. "when, in the judgement of the mana-ger, a local employee has reached the required level of training and effi-ciency, such local employee shall replace the member of the manager'sstaff"). This is thought to be unsatisfactory from the owner's point ofview as no criteria are set for objectively determining when training hasbeen 'completed." Equally, training plans imposed by owners requiringcertain numbers of local staff to replace the manager's staff each yearseem to take little account of the quality or proficiency attained by suchlocal staff. Several successful training programs provided for a continu-ing and joint assessment by owner and manager through a special trainingcommittee.
The emphasis on training in so many management contracts high-lights a key objective for most enterprise owners - to ensure that theimprovements made in management and enterprise performance during thetenure of the contract can be sustained on a long-term basis thereafter.While a "successful" management contract of 3 to 5 years duration may wellreturn an enterprise and its management to efficient performance, it isquestionable whether a contract can be said to have succeeded if manage-ment and enterprise gains are not sustained well beyond the term of thecontract.
In this context, training in its widest sense becomes an all-important feature of a management contract if the owner is using theinjection of management and other skills as the basis for long-termimproved performance. The integrated package of skills, systems, proce-dures and corporate "culture" which is being brought to the enterprise bythe management company has to be effectively transferred to the managementand other personnel of that enterprise. This requires not only a deter-mined training effort on the part of the management company (assisted, ifnecessary, by an external training group); but also a commitment on thepart of the enterprise owner to make the investment in necessary counter-part staff at all levels who are capable of assimilating and maintainingthe knowledge and systems transfer. In several cases examined, the momen-tum provided by the manager ran down after contract expiration - not
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because the manager had failed (in one case it had been remarkably suc-cessful) but because the enterprise owner returned to the old, uncompeti-tive salary structures and incentive systems, reverted to earlier prac-tices, lost the trained personnel and, ultimately, dissipated the gainsachieved under the management contract.
Several commentators indicated that the end of the managementcontract was the true beginning of the enterprise owner's task - ensuringthat the improvements are sustained. Training then becomes linked withlong-term business objectives and is one of the important means of realiz-ing those objectives with the enterprise's own personnel. Training ofmanagement personnel (as opposed to technical training) requires greatereffort and commitment on the part of owner and manager if longer termbusiness performance is to be sustained. Very few of the contractsreviewed revealed imaginative or well-conceived training plans other thanin the strictly technical area. This is an area which is receivinggreater attention in more recent management contracts. It is noteworthythat in establishing the African Management Services Facility, the Bank'saffiliate, IFC, commissioned a separate study on training aspects. It wasrecognized that enterprises had to treat training as a special area undermanagement contracts and that the true gains available under managementarrangements of this nature lay in the quality of the local management andtechnical personnel remaining after the contract had ended.
6.9 Transfer of Tecbnology
The transfer of technology by a management company can berequired through the use of provisions which approximate a licensingagreement. Where this is a central objective of the particular project oroperation, it is questionable to what extent it should be included in themanagement contract and not, perhaps, in a separate technical assistance,technology transfer or know-how agreement.
Several of the contracts reviewed stated in specific terms thetype of technology to be transferred and the methodology and timing forsuch transfer. In most other contracts which did not have separate tech-nology or licensing agreements accompanying them, provisions on technologytransfer tended to be vague or restricted to the manager "keeping theowner informed" of developments or research in areas of specific inter-est. It is doubtful whether such provisions can be beneficial to ownersand perhaps indicates an inadequate focus by the owner on the technologytransfer objectives of the contract.
Another, and sometimes equally important element of "technology"transfer, is the transfer of the corporate skills and managerial know-howfrom the manager to the eniterprise. It-is surprising that in many manage-ment contracts, this element, while expected or possibly referred to inpassing, is not given the attention warranted. Most companies providingmanagement services in a particular industry have developed their own sys-tems of management, financial control, accounting and planning, informa-tion systems, and inventory control which have been proven in their own
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operations. The transfer of these management and corporate skills andtheir proper adaptation to local conditions by the manager is an areaequally important as the training of local personnel.
6.10 Compensation
The range of compensation provisions in management contracts isas varied as the number of management contracts. The overall financialarrangements are dealt with in Chapter 7. However, the main compensationelements in a number of contracts reviewed contained three main features.First, charges for the provision of the management company's personnel inaccordance with an agreed formula, such charges including a small profitelement. Second, agreed reimbursable costs. Third, incentive paymentscalculated in accordance with an agreed formula.
The most highly developed formulas can be found in hotel manage-ment contracts where there are accepted and competitive compensation pack-age structures. In addition, the formulation of compensation in the hotelindustry is sometimes aided by reference to industry-accepted accountingcodes such as the "Uniform System of Accounts for Hotels", as adopted bythe American Hotel and Motel Association. In most other sectors there areno market-oriented guides for structuring the compensation package.
Incentive payments may be based upon a production bonus and/or aprofitability bonus which become payable upon the achievement of levels ofperformance sufficient to establish the long-term viability of the enter-prise as a commercial entity. Such payments should constructed in such away as to ensure that production levels are not achieved by sacrificingcosts and the longer term viability of the operation. Incentive paymentscan also be controlled by review and approval provisions for capital andoperating budgets, work plans and annual production schedules.
6.11 Duration
Management contracts are valid for a specific duration and areoften extendable for further periods upon the agreement of both parties.There is no term which is standard in management contracts but 3 to 5years is normal depending upon the scale and complexity of the problemsfaced.
Sometimes the duration is fixed for a period anticipated by theowner as being sufficient for the manager to complete a training programfor local staff. Sometimes the duration relates to the expected start-upperiod of a new commercial enterprise. In other cases, the duration of acontract is much longer either because the nature of the operationrequires it (i.e. mining development or crop plantations); or because themanager will not commit its resources unless it has an assurance that itsname and personnel will be a part of the operation for a long period oftime. International companies in most sectors will be reluctant to risktheir corporate reputation to undertake a project or operation in anunrealistic time frame. This is often cited as the reason for the longduration of hotel contracts (15-20 years) but is probably more related tothe manager's interest in reaping long term gains.
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6.12 Liability and Indemnification
The question of liability takes on an added significance in thecase of large industrial projects, especially those where the contractrequires the management of refineries, chemical/fertilizer complexes ormining operations.
If the management company is vested with full authority to man-age and control the day to day operations of a plant or operation, it willin effect be in control of most of the factors which could lead to anaccident or breakdown in safety procedures, (unless the owner or enter-prise specifically reserves to itself or its own nominated personnel res-ponsibility for such areas). Management companies are understandablyreluctant to take on unlimited liability in operations which they managebut often seek to impose quite unrealistic limitations upon their lia-bility.
In this area it is impossible to generalize and the facts ofeach situation need to be assessed to ensure that the interests of theowner or enterprise are adequately protected. The management companyshould bear a degree oiE responsibility and liability which is propor-tionate to its control of the operation or project. Reluctance on thepart of the management company to accept a degree of liability sometimesstems from the fact that it is difficult to arrange adequate insurancecoverage for projects in certain countries.
In a contract for mine rehabilitation in Ghana, the managementcompany's limit of overall aggregate liability was negotiated to a levelwhich was deemed by both the enterprise and the management company to bereasonable given the circumstances of the mine, operational conditions andother relevant factors. Particular attention was paid to the possibilityof environmental damage, waste of ore and safety aspects. Detailed indem-nification and insurance provisions were provided in order to identify thespecific types of insurance which had to be taken out during the contractperiod and the limits of such insurance.
A management company will typically not accept liability forindirect or consequential loss or damage (including loss of profits) how-ever such loss or damage may arise. Liability of the management companyis also sometimes governed or influenced by customary industry practices(the oil industry for instance) and it is extremely difficult for an ownerto negotiate a higher liability level than is normally accepted in thatindustry.
6.13 Other Provisions
As with any contract, a management contract contains provisionscovering such areas as settlement of disputes, governing law, taxation,non-assignment, notices, compliance with local laws, force majeure,procurement, termination and the like.
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The law of the country in which the contract is to be performedwill be the law chosen to govern the contract in most cases. However,most managers, if not drawn from that country, will insist upon interna-tional arbitration with organizations such as the International Chamber ofCommerce, ICSID or other recognized bodies. In view of the nature of therelationship and the number of potential areas for disagreement, particu-lar attention should be paid to the arbitration provisions.
One matter which might be noted is the taxation of managementfees and the repatriation and convertibility of moneys earned by themanagement company under the contract. These matters, which are of vitalimportance to the management company, are often not examined by the par-ties until negotiations. Where the owner is the government, governmentpolicy or regulations on the treatment of management fees, moneys earnedand repatriation of such moneys should be examined. A determinationshould be made at the pre-negotiation phase whether the overall invest-ment/taxation regime is conducive to management contract arrangements andwhether the particular circumstances of the proposed contract (i.e., itsimportance to a key industry or foreign exchange earner) is such as towarrant a review or modification of such regime.
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CHAPTER 7
FINANCIAL ARR NEMETS
7.1 General
The structuring of the financial arrangements under managementcontracts varies widely from sector to sector and will inevitably be theproduct of a compromise by the parties. one of the major difficulties infixing the level and method of payment is that there is rarely any assist-ance from, or reference to, market mechanisms. Management contractsinvolve the transfer of a package of skills which may be unique to onecompany. The pricing of that package will to a large extent be arbitraryand the result of a compromise i.e. what the purchaser is ultimately will-ing to pay and the contractor willing to accept in all the circumstances.
In the developing country context, the settling of the financialarrangements is even more difficult because many non-financial factors areat issue. If the parties are unknown to each other, there will naturallybe considerable caution on both sides, each party trying to protect itsinterests. A state-owned enterprise will be under great pressure to keepdown the costs of the contract not only for budgetary reasons but forpolitical reasons as well. The enterprise may be thinking of costs andfinancial structuring in terms of a consulting contract and looking atcosts on a man-month basis rather than on the purchase of a package ofmanagement skills. Conversely, it may try to "unpackage- the skills in anattempt to reduce costs.
The management company will want to sell a total package ofskills, ensure the maximum degree of control and secure a reasonable levelof income. It will not undertake a contract unless it feels that there isa reasonable prospect of profit and a cash flow from day one. The manage-ment company is selling the management services as a part of its businessand will not assume uncommercial risks however much the contract may bedesired. Ultimately, the management company has a board and shareholdersto satisfy and profit will be uppermost in its thoughts.
The enterprise will normally be in a weak bargaining position.It lacks the management and technical skills required to operate the busi-ness and probably does not have a wide choice of contractors who can dothe job. In such circumsitances, the enterprise has to analyse what it canafford, and whether there are any other benefits to the contractor whichcould be bargaining levers.
There may well be strategic benefits to the contractor in termsof new markets, new sources of raw materials, control over supplies, anopportunity to enter a country where direct foreign investment as such isprohibited. These "benefits" need to be quantified by the enterprise.The government may be in a position to make tax and exchange control regu-lations more favourable or to ensure that fees, interest payments, divi-dends, and other payments are easily remitted overseas. In other words,there could well be a number of "indirect" bargaining levers besides moneyavailable to the owner.
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A list of various compensation packages, their features, advan-tages and disadvantages are summarized in Table 4. The following sub-sections describe various elements sometimes found in different combina-tions in compensation packages.
7.2 Annual Fixed Fee
While this is comparatively rare in the contracts reviewed andin general practice, it is a form of payment which many management compan-ies prefer and attempt to negotiate at the outset. Several of the compan-ies interviewed stated that the annual fixed fee provided a guaranteedsource of income and minimized the risks to which they might be subjec-ted. They emphasized that in order to set an annual fixed fee, they hadto ensure that costs were meticulously calculated and that this was ofbenefit to the domestic enterprise.
This was not an entirely convincing argument because they stillwished to be protected against inflation and for the annual fixed fee tobe subject to escalation! In those contracts where an annual fixed feewas found, it was probable that the contractor might also be deriving abenefit from other areas of activity, i.e., sales to the enterprise, asource of raw materials or the opening of a new market. In other words,an annual fixed fee set at a reasonable level was negotiated not becauseit guaranteed the recovery of all costs plus a profit element but becauseit was a convenient cash flow mechanism which was complemented by otherindirect but perhaps more important strategic benefits.
An annual fixed fee is rarely acceptable to a state-owned enter-prise. First, it is difficult to determine a reasonable level and thereare few (if any) benchmarks against which to measure what might constitutea "reasonable" level. Second, the contractor is bound to build in costand inflation elements (if there is no escalation clause) and a profitelement, all of which adds up to a figure which is regarded as astronomi-cal by the enterprise. Third, in many developing countries, annual fixedfees are regarded with suspicion and are politically unacceptable. Theremay also be a perception by the government that the contractor is receiv-ing indirect benefits in the form of market opportunities, sale of goodson favourable terms, dividends (where there is an equity participation)or other benefits and that the annual fixed fee should not be calculatedwithout some attempt to quantify such indirect benefits and therebyreduce the fee.
The most valid objection the enterprise can make against theannual fixed fee payment is that there is absolutely no guarantee of per-formance. Whatever the level of performance, the fixed fee must be paid.Against this, management companies have stated that their corporate repu-tation and future business prospects in the country are sufficient guaran-tee of performance. While these are undoubtedly potent factors whichwill motivate companies which enjoy (and must protect) an internationalreputation, it is not a convincing argument at the political level. Thecompany's interest in the enterprise will probably be less if payment isassured and there is no additional benefit to the management company ifabove average performance is achieved.
Table 4
VARIOUS COPESATION PAXMCK S: FEAJURES
.. el Management Fee Other Nm-Finawital
(Anmual Fixed Fee) Fixed Fee + Cbts Fee As Percentage Incentive Payments Cinossioes Benefits
o Fixed lump sum o Management Fee o Fee as percentage o Based on: o Used largely for: o Purchase agreements
+ Costs of profits - increased - purchasing for raw materials
o Payment based production - marketing
on agreed bench- o As percentage of - profitability - ancillary o Access to domestic
mark sales - fuel or input operations market
conservation o Opportunities for
Fores o As percentage of - plant + equip.aent o Follows industry direct investment
production efficiency and practice o Favorable taxes and
availability exchange control
- achievement of o Dividends
localization o Interest payments
targets o Facility of overseas
- others remittance
o Cost would be o If services for o Guaranteed perfor- o Reward linked to
known in advance which fees are mance results and
charged are performance
o Fee normally clarified, owners o Offers incentiv2
.Adantages static can assess charges for increased o With use of
to profitability and ceilings, ownersI
Ombers o Possible to o Possible to deter- production and managers know Ln
compare fees mine fee and maximum cost and
whether owner can potential earnings
afford fee of contract
o Difficult to o Lack of formal o Reluctance to tie o Few managers con-
determine reason- performance fee to non-perfor- tract under this
able fee withuut guarantees mance related basis alone
market standards serviceo Possibility that
o Higher cost for o Difficulty with managers will
Dtsadvantage enterprise because determining index attempt to
to of possible hidden to be used as base achieve autcome
Owners charges by sacrificing
o Could be complicated costs
o Politically by issues of trans-
sensitive fer pricing
o Offers no guaran-tee of performance
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Assuming that the enterprise could negotiate a reasonable andnon-escalating fixed fee (i.e., a fee fixed at a level which it felt wascommercially and politically acceptable), such a method might be advanta-geous for the following reasons: the absolute cost of the contract (andthe foreign exchange burden) would be known in advance and could be pro-perly budgeted; the management company's income would remain static inspite of rising costs and higher sales volume; where a bidding process wasinvolved, the bid could be more easily compared and evaluated; and thecost of an annual fixed fee may be lower than incentive payments which area relatively unknown factor in terms of ultimate levels (unless ceilingsare imposed).
7.3 Fixed Fee Plus Costs
The fixed fee plus costs is a more normal arrangement but isstill open to criticism because of the lack of any performance guarantee.In a fixed fee plus costs methodology the fee can be reduced by the exclu-sion of costs but the reimbursable costs require careful definition. Thefinancial provisions of a management contract placed on a fixed fee pluscosts basis would be structured in much the same way as a consultingcontract.
In defining reimbursable costs under a management contract,there may be greater emphasis on the proportion of head office costs to beincluded depending upon the role to be played by head office. A number ofmanagement companies structure their operations in such a way that fulluse can be made of head office personnel, systems and facilities and thisfactor has to be accounted for accordingly.
It would appear that the fixed fee plus costs methodology hasbrought more attention to bear upon the fixed fee component because itrepresents not only the profit element but perhaps other elements such asperceived country risks, potential competition risks from the enterpriseand constraints placed upon the contractor's other projects. Governmentsand state-owned enterprises are hesitant to pay large management feeswhen all the contractor's personnel costs, reimbursable costs and suchother defined costs as may be applicable have been fully covered.
7.4 Percentage Fees
In place of a fixed fee, the parties to a management contractsometimes prefer to stipulate a fee based upon a percentage of profits,sales or production (as the case may be).
A profits-based fee can be calculated in a number of differentways--principally on the basis of pre-tax or post-tax profits. There are,however, a number of difficulties encountered during negotiations on themeans of calculating profit. While a number of the contracts reviewedcontained profits-based fees, there was a general awareness that thismethodology had some inherent risks. The unscrupulous contractor mighttry to attain short-term profits by sacrificing longer-term advantages.
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Where the contractor is engaged in sales to or purchases from the enter-prise and has the ability to make adjustments on charges for such sales orpurchases,the question of transfer pricing and the manner in which it canprejudice profit-related fees will arise.
Few contracts reviewed provided for fees based purely on profitsand this may be because the owner felt that relating fees to profits didnot necessarily create an incentive for the manager to achieve optimumproduction in the long term; that profits do not necessarily stem frommanagerial competence but from factors outside the control of the manage-ment; or because the contractor might be reluctant to accept a profits-related fee when it may be prevented from making profits for reasons be-yond its control. However, a number of contracts did provide for a combi-nation of fees based on a percentage of profits and sales or profits andproduction.
Fees based on a percentage of sales were either based on a pro-portion of total sales or of the number of units sold. Sales are obvious-ly preferred by management companies as a basis for fees because sales aremore predictable than profits and will probably occur sooner than pro-fits. The risk to the enterprise is that the manager will attempt to boostthe volume of sales without attempting to control or reduce costs. Thisis equally the risk where production is used as a basis. In practice, anyform of percentage fee which allows one party to prosper while the othersuffers a drop in income or profitability is inherently unsatisfactory.
7.5 CAmissions
A range of commissions have been found in a number of managementcontracts including purchasing commissions, marketing commissions and com-missions for operating related functions. Whether or not part of the com-pensation package is based upon a commission seems to depend largely uponthe practice of a particular industry.
7.6 Incentive PaymeDts
In the more recent management contracts, part of the compensa-tion package is represented by a scheme of incentive payments. Given thecost of management contracts, owners and enterprises are concerned toensure that the objectives which have been set are in fact achieved andthat the management company is rewarded by results and performance.
Depending upon the owner's objectives, incentive payments can bedevised to reward increased production, profitability, fuel conservation,plant and equipment efficiency and availability, sales, achievement oflocalization targets and a range of other benefits which the owner wishesto realize through the means of the management contract.
In structuring the incentive scheme, experience has shown thatthere should be a reasonable balance between the fee component, the reim-bursable costs and the incentive payments. Few, if any, management com-panies contract on the basis of performance-related payments alone, evenif they have favourable cost reimbursement provisions in the contract.
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This is not because they doubt their own capabilities but because whateverthe extent of their management control over the particular operation,there are still many factors entirely beyond their control which mayprevent them from performing to the levels anticipated. Government inter-ference, non-approval of important matters by the Board of the enterprise,lack of foreign exchange for essential capital expenditures, changes ingovernment policy, events of force majeure and the like have all beencited by management companies as matters which have frustrated performanceand their ability to earn the incentive payments.
While incentive payments are undoubtedly attractive to manage-ment companies, they should be structured to ensure that the companies arenot presented with a bonanza if circumstances turn out to be unexpectedlyfavorable or anticipated levels of sales or production have been under-estimated. Normally, some scaling down of incentive levels in specifiedcircumstances is provided for in the contract to cover such eventualities.
Where increased production is one of the objectives of theowner, care should be taken to ensure that the management company does notachieve higher production levels by sacrificing costs. Production hastherefore to be linked (if applicable) to profitability or achievedstrictly within the limits of approved budgets. The importance of theBoard of the enterprise being in a position to assess independently workplans, budgets and technical matters is vividly illustrated in this area.If the Board is not capable, or if it does not have recourse to indepen-dent advisers, the manager can underestimate production levels, inflatethe budget and ostensibly achieve above average output.
7.7 Performance-Oriented Trends
As management contracts and their workings have become betterknown in international business, a growing emphasis has been placed uponensuring performance--both to achieve the overall objectives of the con-tract and the managerial/financial benefits promised by the contract.
It is important to pay careful attention to the structuring ofthe contract, particularly a clear exposition of the objectives, the meansby which those objectives are to be achieved and the achievement of aperformance-oriented compensation package.
Management contracts are primarily designed to improve the man-agement environment and the many corporate areas and activities whichdepend upon effective and efficient management. The introduction of tar-gets, incentive payments and other rewards related to performance are morelikely to ensure committed and progressive management by the managementcompany than the traditional fixed fee concept. Performance-oriented con-tracts impose positive burdens upon the enterprise itself in that thelocal management (and government where a state-owned enterprise is invol-ved) must ensure that it works towards the creation of both an internaland external environment which will make achievement of agreed targets andlevels of performance feasible.
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Agreed levels of performance, for both the enterprise and themanagement company, also provide a reason for monitoring performance andtaking timely action to improve performance where it is tailing off orbeing impeded by external factors. The use and design of management con-tracts are not technical issues but rather tools to achieving economicand/or financial viability, transferring of business concepts and systemsand/or training of management and workers. These broader objectives mustguide the development and implementation of management contracts. Levelsof performance and the setting of targets should, therefore, be realisticand take account of the factors which could affect desired performance orresults.
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BIBLIOGRAPHY
In preparing the study, written materials from a wide variety ofsources, published and unpublished, were reviewed. The following onlyoutlines several of the more important reference materials used and doesnot list materials from. World Bank reports, corporate reports, governmentsources, and newspapers.
Brooke, M.Z. (1985) Selling Management Services Contracts in InternationalBusiness, originally published by Holt Rinehart and Winston but cur-rently handled by Cassells in England and the New York University Pressin the United States. This is by far the most comprehensive availablepublication on the whole subject of management contracts, and itselfcontains a most valuable bibliography.
Brooke, M.Z., Holly, J., and Webb, P. (1983) "International ManagementContracts," report presented to the Leverhulme Trust, 2 Vols., Univer-sity of Manchester Institute of Science and Technology, processed.
Eyster, J.J. (1977) "Negotiating the Hotel and Motor Inn Management Con-tracts," Real Estate Review, 7 (Summer): 35-43.
Gabriel, P.P. (1967) The International Transfer of Corporate Skills:Management Contracts in Less Developed Countries, Cambridge, MA:Harvard University Press.
a (1967) "From Capital Mobilizer to Management Seller," ColumbiaJournal of World Business, 2 (March-April): 7-16.
_ (1972 a) "Adaptation: the Name of the MNC's Game," ColumbiaJournal of World Business, 7 (November-December): 7-14.
. (1972 b) "Multinational Corporations in the Third World: IsConflict Unavoidable?" Harvard Business Review, 50 (July): 93-102 andThe McKinsey Quarterly, IX (2): 2-15.
Ghai, Y. (1984) 'Management Contracts in Africa' The Africa Guide, SaffronWalden: World of Information.
Ghai, Y, and Choong, T.C. (1986) "Management Contracts and Public Enter-prises in Developing Countries." International Center for PublicEnterprises in Developing Countries, Ljubljana.
Mertz, R.A. (1985) "Demand for Management Services in Africa," Interna-tional Finance Corporation, Washington, D.C.
________ (1986) "Public Enterprise Demand for Management in Sub-SaharanAfrica," International Finance Corporation, Washington, D.C.
Sharma, D.D. (1983) Swedish Firms and Management Contracts, UppsalaUniversity.
United Nations (1983) Management Contracts in Developing Countries: AnAnalysis of Their Substantive Provisions, New York: United NationsCentre on Transnational Corporations.
WORLD BANK TECHNICAL PAPERS (continued)
No. 33. Guidelines for Calculating Financial and Economic Rates of Return for DFC Projects(also in French, 33F, and Spanish, 33S)
No. 34. Energy Efficiency in the Pulp and Paper Industry with Emphasis on Developing Countries
No. 35. Potential for Energy Efficiency in the Fertilizer Industry
No. 36. Aquaculture: A Component of Low Cost Sanitation Technology
No. 37. Municipal Waste Processing in Europe: A Status Report on Selected Materialsand Energy Recovery Projects
No. 38. Bulk Shipping and Terminal Logistics
No. 39. Cocoa Production: Present Constraints and Priorities for Research
No. 40. Irrigation Design and Management: Experience in Thailand
No. 41. Fuel Peat in Developing Countries
No. 42. Administrative and Operational Procedures for Programs for Sites and Servicesand Area Upgrading
No. 43. Farming Systems Research: A Review
No. 44. Animal Health Services in Sub-Saharan Africa: Alternative Approaches
No. 45. The International Road Roughness Experiment: Establishing Correlation and a CalibrationStandard for Measurements
No. 46. Guidelines for Conducting and Calibrating Road Roughness Measurements
No. 47. Guidelines for Evaluating the Management Information Systems of Industrial Enterprises
No. 48. Handpumps Testing and Development: Proceedings of a Workshop in China
No. 49. Anaerobic Digestion: Principals and Practices for Biogas Systems
No. 50. Investment and Finance in Agricultural Service Cooperatives
No. 51. Wastewater Irrigation: Health Effects and Technical Solutions
No. 52. Urban Transit Systems: Guidelines for Examining Options
No. 53. Monitoring and Evaluating Urban Development Programs: A Handbook for Program Managersand Researchers
No. 54. A Manager's Guide to "Monitoring and Evaluating Urban Development Programs"
No. 55. Techniques for Assessing Industrial Hazards: A Manual
No. 56. Action-Planning Workshops for Development Managment: Guidelines
No. 57. The Co-composing of Domestic Solid and Human Wastes
No. 58. Credit Guarantee Schemes for Small and Medium Enterprises
No. 59. World Nitrogen Survey
No. 60. Community Piped Water Supply Systems in Developing Countries: A Planning Manual
No. 61. Desertification in the Sahelian and Sudanian Zones of West Africa
No. 62. The Management of Cultural Property in World Bank-Assisted Projects: Archaeological,Historical, Religious, and Natural Unique Sites
No. 63. Financial Information for Management of a Development Finance Institution: A Guideline
No. 64. The Efficient Use of Water in Irrigation: Principles and Practices for ImprovingIrrigation in Arid and Semiarid Regions
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